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The end game?

Year Ahead 2017Chief Investment Office WM English edition

UBS House View

Jürg ZeltnerPresident UBS Wealth Management

Dear reader,

The election of Donald Trump and Brexit were two of the biggest shocks in modern political history. They demonstrate that risk is much easier to find than return in today’s markets. We want to help you redress this im balance.

I hope this Year Ahead gives you the nec-essary context to understand and thrive in today’s turbulent markets, addresses some of your most important questions and concerns, and provides you with ideas and approaches to help you achieve your investment goals.

Some of our solutions are time-tested. Diver-sification is all the more important amid ris-ing political discord and protectionism: if the

world economy becomes less global, inves-tor portfolios need to become more global. It remains at the core of our investment approach.

Other solutions are newer. With prospec-tive returns diminished for many assets, investors will need to be more creative than simple “buy-and-hold” in liquid markets. This means employing different investment approaches: investing in new asset classes, harnessing illiquidity, and exploiting alter-native investment return factors.

Our client promise is to protect and grow wealth, together, over generations. I want this Year Ahead to be just one step along our journey.

Highlights

Content

10 Around the world

12 The end game?

18 Main lessons learned in 2016

23 7 questions, 7 answers for 2017 24 What will a Trump presidency mean for

markets? 27 Is anti-globalization a threat to my wealth? 30 What are the main risks for 2017 and how

should I deal with them? 33 How can I achieve 5% returns? 36 Can markets survive without easy money? 39 China: Risk or opportunity? 42 Does the future of Europe matter for

markets?

47 Top 10 ideas for 2017 48 US equities 50 EM equities 53 EM FX basket 56 APAC REITs 58 Dividends and buybacks 61 US senior loans 63 US TIPS 66 Palladium and platinum 68 Alternatives 71 Sell high grade bonds

77 Long-term investments 78 Education 82 Emerging market healthcare 86 Energy efficiency

90 Portfolio investing 97 Equities 100 Bonds 103 Alternative investments 105 Commodities 107 Foreign exchange

110 Heard around CIO

113 Forecasts

The end game?

Politics and policy have played a huge role in financial markets in recent years. It will be no different in 2017. Learn more about the impact of policy on markets in our interactive game at ubs.com/cio, and see why we believe global diversification is so critical in today’s polarized political world.

Play the The end game on ubs.com/cio, and read more from page 12.

click on the article

US and EM ideas in focus

US equities, US senior loans, and US inflation-protected securities are among our top ideas. We also believe emerging market growth can endure in 2017, and highlight opportunities in EM equities and an EM currency basket.

Pressing questions

We respond to the pressing ques-tions our clients have been asking as we approach the end of the year. Find out what a Trump presidency will mean for markets, how inves-tors can prepare for the 28+ risks we face in 2017, where investors can find return in today’s low-yield world, and more.

Learn more in 7 questions, 7 answers for 2017 starting on page 23.

Look up our Top 10 ideas for 2017 starting on page 47.

New ways of finding return

The search for yield will continue in 2017: risk-free interest rates will be below the rate of inflation in much of the financial world. Investors looking for more effec-tive portfolios will need to consider diversifying into hedge funds, investing in illiquid assets, and benefiting from alternative invest-ment return factors.

For the long term

In a turbulent world, companies which will benefit from immutable trends like urbanization, popula-tion growth, and aging can provide long-term investors with welcome respite. We highlight education services, healthcare in emerging markets, and energy- efficiency solutions, offering exclusive interviews with entrepre-neurs and industry experts.

See our portfolio investing ideas starting on page 90.

Experience the power of long-term invest-ments on ubs.com/cio, and from page 74.

” The future ain’t what it used to be.”– Yogi Berra

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Around the world

EM-provingIn spite of political uncer-tainty, we are positive on emerging market (EM) equities and select EM currencies, as EM econo-mies revive. (see page 50)

Dollar doldrums? We forecast the euro and the British pound appreciat-ing relative to the US dollar in 2017. (see page 107)

Fiscal trumps monetaryWe expect the Federal Reserve to hike rates once in December and twice in 2017, but new fiscal stimulus should support growth and inflation is likely to rise more than rates. We are positive on TIPS. (see page 63)

Earned itWe are positive on US equities, anticipating 8% earnings growth in 2017. US technology, financials, and healthcare are pre-ferred sectors. (see page 48)

Move on up We forecast US GDP growth of 2.4% in 2017, up from 1.5% in 2016, due to higher wages and low mortgage and gas prices. US equities should continue to climb. (see page 48)

11Investment views · Financial news · Economic thoughts

Gentle descent We expect China to man-age its slowdown effectively, with growth of 6.4%. We anticipate USDCNY moving to 7.00 in 12 months. (see page 39)

Building momentum We are positive on REITs in Australia, Singapore, and Hong Kong, which should benefit from an ongoing global hunt for yield. (see page 56)

Alpine dividendsSwiss equities could under-perform global equities in a rising market. But Swiss stocks paying sustainable and growing dividends remain appealing. (see page 59)

For the long haulWe see long-term invest-ment opportunities in EM healthcare, education, and energy efficiency. (see page 74)

Lights, camera…taperWe anticipate Eurozone growth of 1.3% in 2017 from 1.6% in 2016. The ECB may taper its QE program, but will retain accommodative policy. (see pages 36–37)

Beware the ballot Elections will be held in the Netherlands, France, and Germany. Investors will need to be conscious of more anti-establishment support. (see page 42)

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The world’s long-term economic prob-lems are well known – rising debt, aging populations, and muted growth. But it is not these problems alone that will drive markets in 2017. As in 2016, policy is likely to prove the decisive factor. Play out your own policy choices in our interactive game at ubs.com/cio

Many investors we speak to believe that a “reset” for financial markets is overdue. The case seems simple: every-one can see that markets have risen consistently, yet so have inequality, debt, dependency ratios, and social ten-sions. Meanwhile, growth, investment, and productivity are weak. It looks like something’s gotta give.

However, we have to remember that the “everyone” who can see the global economic problems includes policymakers and electorates worldwide. And they have shown they are willing to pursue increasingly extreme measures to solve the

Mark HaefeleGlobal Chief Investment Officer

The end game?


issues at hand. Here are some simple thought experiments: faced with a lack of growth, will a central bank that has already distorted the local bond market choose to stop, or start buying equities? Or, faced with rising overseas competition, will voters stick with the status quo, or turn to protection-ism? The answers to these questions, and many more like them, will matter a great deal for your portfolio.

The Year Ahead In 2017, policymakers and voters will again be faced with a series of such trade-offs.

Developed market central banks have noted that inflation is beginning to rise, but also that employment is still below pre-crisis peaks. China’s leaders know the country needs to maintain growth and employ-ment, but rapidly rising debt ratios and house prices suggest growth may come at a cost. Elsewhere, politicians facing elec-tions in 2017 may believe that trade and immigration are helpful for growth, but Brexit and the election of Donald Trump demonstrate that protectionist policies are becoming more popular among voters.

The issues policymakers choose to focus on in the year ahead, and how they choose to address them, will heavily influence mar-ket performance. Therefore, understanding their most likely choices is a critical part of our investment process. We need to ask ourselves the right questions: “what does policymakers’ past behavior tell us?”, “what are they trying to achieve?”, “how are they incentivized to act?”

In our base case, we believe that central banks in the US and Europe will continue to err on the side of loose monetary policy,

even if it comes at the cost of higher infla-tion. The behavior of central banks since the financial crisis suggests that growth, employment, and near-term support for the economy have a higher priority than concerns about potential longer-term con-sequences of their actions. Recently, Fed Chair Yellen has re-confirmed this by dis-cussing running a “high pressure economy” (i.e. above-target inflation) in order to stim-ulate employment growth. And ECB Presi-dent Draghi has dismissed some of the claims of negative side-effects to his policies.

We will be alert for a change in this modus operandi in the year and years ahead. But as we enter 2017, we believe this means equities can remain supported (see pages 48 and 50), mostly in the US (page 48), and investments with a decent yield will remain sought after (page 33). Investors will also need to consider means of hedging port-folios against rising inflation (page 73).

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Meanwhile, for the Chinese government, maintaining high levels of employment and social stability are crucial. It has consistently shown its ability and willingness to inter-vene in favor of short-term stability, at the cost of longer-term reform. We see no reason for 2017 to be different. Medi-um-term risks and debt-to-GDP will contin-ue to rise, but we expect China’s demand to remain relatively stable, and assets ex-posed to that growth will be supported (page 39). Two of our top 10 ideas are ex-posed to emerging markets (pages 50-53).

Like in 2016, the direction of politics is per-haps the most uncertain factor in 2017. Brexit and the election of Donald Trump showed how the political “center ground” is not fixed, and investors need to remem-ber that politicians are incentivized first by electoral success and (by extension) popularity, not GDP and corporate profit growth. Against this backdrop, investors will

need to monitor the impact of a Trump presidency on markets (page 24), the UK’s increasingly complex Brexit process, elec-tions in France and Germany (page 42), and a rising global trend of protectionism (page 27). To cope with this political uncertainty, we believe investors are best served by diversifying across countries and regions, to avoid overexposure to the experimental policies of individual regimes.

Looking longer termOver the longer term, the only certainty is that different countries will choose different paths and see different outcomes. Therefore, we believe diversification across regions and asset classes provides investors with the best way to protect and grow wealth in a world of increasingly complex and difficult choices.

Investors will also need to consider in vesting in trends and asset classes that are less affected by policy. For instance,

The end game?


urbanization, population growth, and aging are contributing to increased demands for education (page 78), healthcare (page 82), and energy efficiency (page 86). For longer-term investments, sustainability is a critical consideration. Alter natives (page 68) may also provide a means for investors to reduce exposure to diverse political out-comes, while seeing capital growth through the cycle.

The end gameTo demonstrate how changing monetary, fiscal, and social policies interact to affect economies, markets, and portfolios, we have created the The end game, an inter-active game on ubs.com/cio. Since the financial crisis, we have consistently run simulations as part of our investment pro-cess. The end game offers you the opportunity to play global policymaker and walk through a simplified version of our scenario analysis.

I think it helps us understand the policy choices, interactions, and iterations that will impact portfolios. I hope it leads you to a deeper discussion of your investments and diversification.

See for yourself at ubs.com/cio

In shortSolving the world’s myriad economic prob-lems is about trade-offs, and the choices that both policymakers and electorates make will matter a great deal for your portfolio. The only certainty is that different countries will make different choices. Diversification is the best way to protect and grow your wealth in an increasingly complex world.

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The end game The end game, an interactive scenario analysis available on ubs.com/cio offers you the opportunity to play policy-maker and to see how solu-tions to the world’s economic issues can affect economies, markets, and portfolios.

What issue would you tackle first?

An aging populationA shrinking working age population makes it difficult to raise sufficient tax. You could encourage immigra-tion, or raise the retirement age.

Lack of investmentMany companies are not investing for the future. You could print money to encourage investment, or spend on infrastructure yourself.

Learn more at:www.ubs.com/cio


InequalityRising inequality is contribut-ing to social tensions. You could raise tax and spend on low-income households, or maintain a policy of printing money.

Polarized politicsExtreme views are gaining in popularity. To stay in power, you could spend money on the disaffected population, or shift your own policy stance.

Financial bubblesSome bonds now have a negative yield. You could increase interest rates to address market distortions, or maintain a money print-ing policy.

Wasteful productionSome industries are unprof-itable without government support. You could with-draw support, or add stim-ulus to try and improve profitability.

Excessive debtGovernment debt levels are high and your country still runs a deficit. You could cut government spending, or print money to finance your debt.

An unproductive workforceProductivity growth remains weak. To improve your long-term growth potential, you could invest in infra-structure, or education.

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Don’t confuse a “base case” with a “done deal“This past year has been one of ignominy for a number of “base case” forecasts. Against all odds, Donald Trump secured the Repub-lican nomination, and then won the US election. The UK voted to leave the EU. Even the apparent masters of the economy – the central banks – were forced to ease policy more than had previously been thought necessary. The Fed forecast in 2014 that interest rates would be 3% by now.

Main lessons learned in 2016In 2016, the value of timeless principles of diversification, re balancing, and hedging were laid clear. The on going search for investment returns means new approaches may be required, too.

1 What to do about it?The good news for investors is that the things the market is worst at fore-casting tend to be relatively specific – elections, interest rates, and economic growth forecasts. By avoiding invest-ing in discrete event outcomes, and instead focusing on broader trends in earnings and monetary policy and diversifying across asset classes and regions, investors can minimize their exposure to identifiable events, find opportunities, and reduce portfolio volatility. Currency hedging is an important part of this, as the politically -driven plunges in the British pound and Mexican peso in 2016 proved.


Don’t panic2016 was a year of shocks, but also one that rewarded investors who remained calm amid the uncertainty. The MSCI All-Country World Index dropped 13% through January and February on concerns about a potential shortfall in China’s for-eign exchange reserves, but recouped its losses by the end of March. June brought Brexit and the worst day for equity markets in recent years, but markets regained their prior highs within just three weeks.

More recently, in the immediate aftermath of Donald Trump’s election victory, the market rebound after an initial sell-off took just a matter of hours.

2 3Don’t underestimate the central banksClaims that monetary policy has “reached its limits” have been made repeatedly. Yet this past year has shown that central banks still have the capacity to surprise. The Euro-pean Central Bank started buying corporate bonds, the Bank of Japan installed an upper bound on bond yields, and the Bank of England resumed quantitative easing.

For investors, these central bank responses have meant that even some negative-yield-ing assets have provided positive returns, and that the search for yield continues.

What to do about it?“Not panicking” and “buying the dips” sound obvious, but can be diffi-cult to follow – after all, market falls often stem from discouraging news. But a disciplined strategy of frequent rebalancing can steady investor nerves by providing a systematic way to sell as markets rise and to buy when mar-kets decline. Our research suggests investors who chose to de-risk US equity positions around uncertain events and remained in cash lost an average of 1.8%. Those who held through earned 12%, excluding divi-dends.

What to do about it?Central banks have engineered high returns in recent years, but are effec-tively suppressing future returns. Investors will need to become more creative. This means seeking out potentially unfamiliar asset classes like hedge funds and private markets (page 68), and exploring new approaches to portfolio construction (see page 90), to generate higher returns in future.

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Main lessons learned in 2016

UBS Industry Leader Network The UBS Industry Leader Network consists of a hand-picked group of client executives and entrepreneurs who operate private companies around the world. Monthly discus-sions and networking events offer insight on the health of the economy, as seen and experienced directly by other business owners. This peer-to-peer learning is a differentiated offering for some of our largest client entrepreneurs. The network provides timely and proprietary insights for our investment process.

Industry Leader lessons learnedWhen surveyed, UBS Industry Leaders highlighted the follow lessons learned in 2016:

• Businesses that don’t adapt to technological change are at risk of falling behind.

• New technologies to enhance manufacturing processes and sup-ply chain management are a key part of competitive advantage.

• Diversification of growth drivers is key. Suppressed commodity prices have dampened demand from affected regional economies like emerging markets.

Industry leaders see the altered political landscape as the biggest change in 2017

Source: UBS

No change

Political landscape

Responses to the question: “How will 2017 be different for your business?“

Technology upgrades

Other

12%

44%

25%

19%

Fig. 1

7 questions, 7 answers for 2017

1. What will a Trump presidency mean for markets?

2. Is anti-globalization a threat to my wealth?

3. What are the main risks for 2017 and how should I deal with them?

4. How can I achieve 5% returns?

5. Can markets survive without easy money?

6. China: Risk or opportunity?

7. Does the future of Europe matter for markets?


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Question 1

What will a Trump presidency mean for markets? Donald Trump’s surprise victory in the US presidential race marks a dramatic shift in the status quo for the world’s largest economy.

The election of Donald Trump added to a year of political surprises around the world, and his policy agenda is a key focus for global markets.

With a Republican majority in both houses of Congress, Trump will have latitude to implement executive decisions that could significantly alter the status quo of US eco-nomic and social policy, with global impli-cations. This period of change could be long lasting. Senate Democrats will need to defend twice as many seats as Republi-cans in the next election, suggesting that the Republicans have a high probability of preserving their majority for the next four years.

CIO believes that investors are well-advised to consider three broad policy areas:

The promise of an expansionary fiscal policy. Trump ran on a platform of tax cuts and higher public spending. He pledged to invest USD 1trn in American infrastruc-ture over the coming decade, and reiter-ated his commitment in his first speech as president-elect. The fiscal stimulus pro-vided by lower taxation and higher federal spending will have broad macroeconomic


and investment implications. Military con-tractors and construction firms stand to benefit, for example. We also expect to see incremental pressure on wage inflation, increasing the appeal of Treasury Inflation Protected Securities (TIPS) versus other US government bonds.

The pledges to enact pro-business policies, lower corporate taxes, and reduce regulation. The president-elect has promised to boost economic growth by scrapping intrusive federal regulations, lowering corporate tax rates, and by reducing the cost of regulatory compli-ance. We believe the US energy sector stands to benefit from operating in a more lenient regulatory environment. The elimi-nation of a risk premium assessed on financial services and pharmaceutical stocks should also free these sectors for better performance next year. Headline risk over drug prices will persist, but gov-ernment intervention is far less likely under the next administration. And companies more broadly could see their tax bills reduced. Pro-business legislation, lower corporate taxes, and reduced regulation can support US equities, where we already expect 8% earnings growth next year.

In shortMore expansionary fiscal policy and pro-business legislation under Donald Trump’s leadership should prove supportive of Treasury Inflation Protected Securities (TIPS) and some sectors of the US equity market. Uncertainty is higher for emerging markets, but we expect growth to provide support through 2017.

“ What separates the winners from the losers is how a person reacts to each new twist of fate.” – Donald Trump

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The threat to trade and immigration. Trump vowed to adopt a tougher negotiat-ing stance with US trading partners. If this translates into policy, it could prove to be a serious economic challenge for Mexico, which relies on the US for 80% of its exports and 98% of the remittances it receives from Mexican workers abroad. CIO believes that a Trump presidency will create some volatility. However, while the shift may pose chal-lenges for some trade-focused emerging nations – such as Mexico, South Korea and Colombia – countries with larger domestic economies like Brazil and India should be less vulnerable. Added to this, US relations with Russia may improve, given indications

of mutual respect between Vladimir Putin and Trump. Barring radical policy develop-ment, we believe the economic and earn-ings revival now underway in most emerg-ing markets (EM) can continue. We head toward 2017 overweight EM equities and select EM currencies.

After the initial uncertainty over his unorth-odox trade and immigration policies abated, equity markets improved on optimism that fiscal stimulus and reduced regulation will promote economic growth. CIO believes that TIPS, US equities, and EM equities can continue to advance through next year. (see pages 63, 48, and 50).


Question 2

Is anti-globaliza-tion a threat to my wealth? The waning global enthu-siasm for trade has raised con-cerns that globalization is reversing. This situation could threaten your wealth, but need not, provided an appro-priate diversification and hedging strategy is in place.

Protectionism looks to be on the rise. After almost three decades of hyper-globalization, we have learned that while its benefits, and those of free trade, tend to be spread across society as a whole, the costs of it can be concentrated, and are often deeply felt by those affected. Amid stagnant me dian incomes and rising wealth inequa lity, resistance to trade is increasing, and pro-tectionist sentiment is on the rise. The political consensus that had promoted trade liberalization is now shifting, with an increas-ing proportion of votes now attainable by offering protectionist rhetoric.

In 2016, Brexit, Donald Trump’s victorious run for the US presidency and tortured negotiations over global trade deals such as the Trans-Pacific Partnership, Transatlantic Trade and Investment Partnership, and CETA pact all demonstrate growing skepti-cism about the merits of globalization.

What are the consequences for investors?The end game (ubs.com/cio) demonstrates how changes in policy can have meaningful consequences for markets, economies, and portfolios. As protectionism rises, we see two main effects:

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Question 2 – Is anti-globalization a threat to my wealth?

In short A trend of rising protectionism increases the risk for investors in small, open economies that rely on a large trading partner. Slower trade is bad for growth, but diversification and currency hedging can shield investors from some of the risks associated with anti-globalization.

First, the markets of smaller, more open eco-nomies that depend on trade with a single larger country or trading bloc are particularly vulnerable. The poor performance in 2016 of the British pound, Mexican equities, and the Mexican peso that resulted from fears of a reverse in trade clearly illustrates this si tuation.

Second, even if countries do not repeal tra de agreements or erect trade barriers, competitive devaluation still remains a risk as countries attempt to boost weak growth through beggar-thy-neighbor currency policies (or policy moves to that effect). Since 2012 the euro, Japanese yen,

What to do about it?If the world economy becomes less global, investor portfolios will need to become more global. Despite the direct fallout from Brexit, UK-based investors exposed to multinationals (whose profits rose in local currency terms) fared well in 2016. As politi cal risks proliferate, investors may feel more inclined to keep money closer to home, where they better understand the political climate. But they will need to fight this instinct and invest in a glob-ally diversified way.

Investors will also need to reduce their vulnerability to global currency risks by hedging overseas investments back into local currency. Anti-globalization ten-dencies raise the risk of sudden declines in individual currencies – hedging can help investors shield local purchasing power from the dangers of excessive currency volatility. Investors who bought

UK or Mexican assets in 2016 without hedging currency likely saw deeply nega-tive returns.

Slower global growth that results from rising protectionism is clearly not a boon for investors. Global trade as a percent-age of GDP climbed from 26.9% in 1970 to a peak of 61.1% in 2008, almost per-fectly matching the rise in global pros-perity. It’s not sur pri sing that the Interna-tional Monetary Fund’s World Economic Outlook (October 2016) cited the return of protectionist measures as a key risk to the continued health of the world’s economy.

But this trend need not unduly impair portfolio performance, provided inves-tors avoid concentration in small mar-kets, diversify globally, and avoid taking undue currency risks.

and British pound – three of the world’s four most heavily traded currencies – have, at some stage, declined by around 20% in the course of a year.


“ Globalization is a fact of life. But we have underestimated its fragility.”– Kofi Annan

0

5

–5

–10200720031999199519911987 2011 2015

10

15

Global trade growth has slowed

Source: IMF

World exports of goods and services (volume growth, %)

Average 1987–2007

World exports of goods and services (volume growth, %)

Average 2008–2015

Fig. 2

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16

12

10

2014

2013

2012

2011

2010

2009

2015

Oct

-May

14–

15

May

-Oct

15–

16

Oct

-May

15–

16

20

18

22

The world is becoming more protectionist

Source: WTO

Trade restrictive measures

Trade facilitating measures

G20 trade measures (average per month)

Fig. 3

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Question 3

What are the main risks for 2017 and how should I deal with them? Even as central bank stimulus drives investors into risky assets, risks are rising. Inves-tors will need to accept, diversify, and hedge to miti-gate them.

Accept We have listed 28 risks that could impact markets in 2017. But the biggest single risk individual investors will face is not displayed. That risk is panic.

Panic can lead to inertia, i.e. investors remaining under-allocated to asset classes essential for their long-term portfolios and forever waiting for the “right time to buy.” It can also lead to selling at the worst pos-sible time. Quantitative market research group DALBAR estimates that investors have lost more than 2% annually over the past 20 years from ill-fated attempts to time markets. In a world where a 5% return can be hard to achieve (see page 33), that is significant.

Creating a long-list of risks to track can help investors accept that many risks exist, keep a long-term mindset and therefore respond in a less emotional manner when risks flare.

DiversifyInvestors can reduce their exposure to some of the risks listed through diversifi cation across asset classes, regions, and securities.


Many of the risks are region or country- specific, so investors who avoid excessive concentration in any one country or mone-tary regime can reduce their vulnerability.

Even when global risks arise, they do not impact all assets equally. For instance, higher inflation might be bad for cash but good for real assets and equities. Or higher inter-est rates might hurt high quality bonds (see page 72) but boost senior loan returns (see page 61). Effective diversification across bonds, equities, and alternatives can lessen vulnerability.

Some risks will also affect individual compa-nies more than entire markets. For instan ce, disruptive technologies and cyber-attack concerns can exacerbate single-security risk while affecting the overall market in only a minor way (see Industry Leader Network insights). Reducing exposure to individual companies generally helps improve financial returns relative to risk.

Hedge Investors can diminish their risk exposure even further through hedging. In an en vironment of increasing protectionism and monetary policy uncertainty, currency

In shortRisks, both foreseen and unforeseen, will impact markets in 2017. Effective planning will be crucial: accepting that risks will affect your portfolio, diversifying effectively, and hedging against unrewarded risks.

“ Plans are nothing but planning is everything.” – Dwight D. Eisenhower

Top risks for 2017

We identify at least 28 known risks that could concern markets at some point in 2017. Unforeseen risks will also emerge.

Economic concernsUS recessionChina hard landingSecular stagnationGlobal inflationStagflationIncreased protectionism

Policy errorsRapid US rate hikesEurozone “taper tantrum“Competitive devaluation

Financial system worriesPensions / insurance crisisEuropean banking crisisLitigationChina FX reserve shortfallJapan debt crisisCompromised market liquidity

Political eventsGerman electionFrench electionEU political crisisVenezuela crisis

Geopolitical risksMigration crisisEscalating Middle East conflict Rise in global terror Anti-globalization

Exogenous shocksRising food pricesOil price spikeDollar squeezeWeather eventsPandemic

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risks are high. This adds to portfolio vola-tility while providing no clear prospect of return. Currency risks should only be taken on a short-term basis, and should generally be hedged in the long run.

Hedging can also prove attractive to inves-tors hopeful of benefiting from rising equity markets, but particularly fearful of global risks, like a US recession or Chinese hard landing. Our Systematic Hedging approach seeks to regularly buy lower-priced protec-tion in less widely traded markets. While this practice comes at a cost, it can lessen inves tor vulnerability to major declines in global stock markets.

Similarly, a systematic approach, allocating to equities when the market backdrop is supportive, and reducing equity exposure when conditions worsen, can help protect against large portfolio draw-downs.

Risks today are numerous. But by accepting, diversifying, and hedging, investors can reduce their vulnerability to more manage-able levels.

Question 3 – What are the main risks and how should I deal with them?

UBS Industry Leader Network cites geopolitics as the biggest risk

Source: UBS

Geopolitics

Disruptive technology

Responses to question “What is the biggest risk to your business today?”

Global recession

Cyber security

Other

9%

15%

39%

21%

16%

Fig. 4

Industry Leader Network Insights

Geopolitical-related risks, disruptive techno logies, and a global recession were the top concerns cited by over 75% of industry leaders.


Interest rates available on cash have been pushed to record lows, as central banks have attempted to revive weak economies. Investors have sought returns elsewhere, but the prices of investment grade bonds, high yield bonds, and equities have now all been pushed up. The search for yield could take on new impetus in 2017, with inflation rising even more quickly than interest rates.

We can’t reasonably expect more return without more risk. And aiming for any set return level if one cannot realistically cope with the associated risk is always a bad strategy.

But assuming risk tolerance is suitably high, we see three ways investors can consider to boost returns in 2017:

1. Investing in riskier assetsFinancial theory tells us that investors can’t expect more return without more risk. But equally, more risk is no guarantee of more return. Investors therefore need to be selective:

Question 4

How can I achieve 5% returns? Ten years ago, generating returns above 5% was relatively simple. Today, with interest rates close to record lows, it is much more diffi-cult, but still achievable.

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Question 4 – How can I achieve 5% returns?

As we enter 2017, some of our preferred areas are:

a) US and emerging market equities. We believe that global equity markets are set to deliver positive returns in 2017, and prefer US and emerging market equities. Accelerating economic growth, improving earnings, and only gradual increases in interest rates should support appreciation in both markets (for more, see US equities, page 48, and emerging market equi-ties, page 50).

b) US senior loans offer an attractive alternative to more “traditional,” low-er-yielding, fixed income investments. We expect the asset class to benefit from resilient US economic data and the global hunt for yield amid still low real interest rates. Senior loans are also “floating rate,” meaning that, unlike most fixed income assets, they will likely benefit as US interest rates rise. At the time of writing they offer a running yield of 5.9% (for more, see US senior loans, page 61).

c) Select emerging market currencies. After years of underperformance, emerging markets finally began to revive in 2016. Although Donald Trump’s electoral victory has added a layer of uncertainty, we believe some emerging market currencies look attractive for investors looking to boost returns. We have a positive view on a basket of EM curren-cies – including the Brazilian real, the Indian rupee, the Russian ruble, and the South African rand, equally weight-ed – versus a basket of equally weighted developed market (DM) currencies – the Australian dollar, Canadian dollar, and Swedish krona. (for more, see emerging market FX basket, page 53).

2. Adding leverageInvestors could also consider leveraging a well-diversified portfolio to improve returns. Current market interest rates are low by his-torical standards, providing a conducive envi-ronment for leveraged strategies. For inves-tors with a high risk tolerance, it may, in some cases, be more attractive to leverage a medium-risk portfolio than to invest directly in a high-risk portfolio.

In shortIn a low-yield world, investors need either to lower their return expectations or take on more risk. US equities, EM equities, US senior loans, and alternatives (hedge funds and private markets) could all help investors boost returns in 2017.


That said, with interest rates expected to rise in the US in the coming years, investors will need to carefully consider their investment time horizon. With prospective returns also low by historical standards, small changes in borrowing costs can have a significant effect on risk-return ratios.

3. Seeking alternative risk premiumsAvailable returns from a traditional “buy-and-hold” strategy in stock and bond mar-kets are lower than before. So we consider it important for investors to now look at a wider range of investment options.

This could include investment in alterna-tives, such as hedge funds and private markets (see page 68). We currently fore-cast 7.2% annual returns over the next 10 years for a balanced portfolio with a 40% allocation to hedge funds and pri-vate markets. New approaches to portfolio construction (see page 90) could also help deliver risk-adjusted returns superior to more traditional methods. A diversified portfolio of partially illiquid global credit assets is expected to achieve 4.9%.

“ How to succeed: try hard enough. How to fail: try too hard.“ – Malcolm Forbes

6.0

6.5

5.5

5.012111098

50% LeverageSharpe Ratio: 0.41

Risk, in %

Retu

rn, i

n %

7 13

7.0

7.5

Leverage increases both risk and return

Source: UBS

Note: The Sharpe ratio is a measure of return, adjusted for risk-free interest rates, relative to volatility.

Forward-looking estimations of risk and return (USD, balanced strategy)



UnleveredSharpe Ratio: 0.45

Fig. 5

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Question 5

Can markets survive without easy money? Markets would struggle with-out easy money. But the era of easy money is not over, even if the US Federal Reserve raises interest rates and the European Central Bank (ECB) begins “tapering” its quanti-tative easing (QE) program in 2017.

Inflation is increasing. Consumer prices in both the US and Europe are climbing at their fastest pace in more than two years. Bond market quivers suggest that investors are beginning to cast a watchful eye on poten-tial central bank responses: higher US inter-est rates and a slower pace of ECB QE. We expect US interest rates to rise to 1.00-1.25% by the end of 2017, and for the ECB to reduce the pace of its bond buying.

Investors have clearly benefited from easy money in recent years. Can they survive without it?

The short answer is no – or at least not yet. Markets have historically performed relatively well in rate-hike cycles, but they tended to come at an earlier stage in the economic cycle, and against a backdrop of strong economic and robust corporate earnings growth. Today, many markets have already reached full valuations, and it seems unlikely that growth will return to what was once considered “normal.” Therefore, investors are right to be mindful of aggressive rate hikes. The “taper tantrum” of summer 2013, when bonds and equities fell in tandem, served as a warning of the kind of market environment investors should be fearful of.


That said, we do not believe that the com-ing year will bring the end of easy money. Indeed, real interest rates could in fact fall to the lowest level in two years as inflation increases more rapidly than nominal interest rates. Like in The end game (page 12), it comes down to a policy decision. Faced with a choice between aggressively hiking rates to combat a still unconfirmed inflation threat or maintaining loose policy to aid deleverag-ing and improve muted growth, central banks remain heavily incentivized to keep interest rates low. The policy orthodoxy remains focused on avoiding repeating the mistakes of the Great Depression, when monetary policy was tightened too soon.

Fed Chair Janet Yellen has pointed out that she is comfortable with inflation that runs above target in order to encourage greater labor market participation. ECB President Mario Draghi “remains committed to pre-serving the very substantial degree of mone-tary easing,” suggesting that the ECB is still heavily predisposed to continue with consid-erable QE, even if the extent of it declines in 2017. And the Bank of Japan has only recently committed to capping the level of bond yields, a policy we expect it to main-tain in 2017.

Against a backdrop of still-easy monetary policy, and a potential loosening in fiscal policy in the US under the new leadership, we overweight the US equity market (see page 48). We also overweight US senior loans (see page 61), which can benefit from investors’ hunt for yield in a negative real rate environment and provide some insula-tion against rising rates, thanks to their vari-able coupons. US inflation-protected bonds (TIPS) will also likely outperform nominal high grade bonds when inflation increases.

Investors should also consider allocations to less-correlated assets, such as hedge funds and private markets. History shows us that, even if interest rates remain low, equities and bonds can move in tandem when mar-kets fear turning points in monetary policy, which raises portfolio volatility for diversified investors. Even if such episodes of higher volatility have typically lasted for only a few months, hedge funds can reduce vulnera-bility to this uncertainty. Meanwhile, private markets investments can help prevent ill-advised emotional responses to volatility that can permanently impair wealth.

In shortWe expect the US Federal Reserve to raise interest rates and the European Central Bank to taper quantitative easing in 2017. But policy will remain accommodative as the focus stays on stimulating economic growth and employment. Against this backdrop we overweight US equities, US senior loans, and Treasury Inflation Protected Securities.

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0

1

US

inte

rest

rat

es m

inus

CPI

infla

tion

(%)

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ay-0

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ar-0

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l-16

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17

2

3

Gold should be supported by even moredeeply negative US real interest rates.

Source: Bloomberg, UBS

Fig. 6

“ Central banks always try to avoid their last big mistake.” – Milton Friedman


Question 6

China: Risk or opportunity? An overheating property market and rising financial leverage mean that China has the potential to spook markets once again in 2017. But opportunities abound in the country’s transition.

A “China panic” or two has become par for the course in financial markets in recent years. Global equities dropped 4% in August 2015 after a surprise change in China’s currency policy. And they fell 11% in the first weeks of 2016 on fears that China’s capital outflows were running out of control.

In 2017, it seems as though there is plenty of fodder for similar fears to resurface. Parts of the property market appear to be overheating. Prices in Tier-1 cities are up by close to 30% year over year, and prices in Shenzhen are now the most expensive in the world on a price-to-income basis. The average 100 sqm property sells for almost 20 times average income. The yuan has depreciated and foreign exchange reserves have begun to fall again in recent months. And financial leverage continues both to rise and to become less productive. The total debt-to-GDP ratio in China has climbed from 150% before the financial crisis to around 250% today, and it now takes approximately four yuan of credit to gener-ate one yuan of growth.

Dealing with these issues will clearly entail risk. Tightening measures on the property

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Question 6 – China: Risk or opportunity?

market, if too severe, could have a chilling impact on the wider economy. Real estate has accounted for close to 10% of GDP growth in the past year. And slowing debt growth by shutting down unprofitable industries will be difficult without provok-ing higher unemployment and social insta-bility. Fears of an economic “hard landing” could lead to market volatility at times.

But, as mentioned in The end game? (page 12), we believe China’s outlook ultimately comes down to the incentives of its leader-ship. We believe growth and stability are likely to take precedence over long-term reform, if it comes down to a straight choice. The country’s largely captive domestic sav-ings base and current account surplus (USD 260bn) mean the government’s hand is rarely forced by the market. And consump-tion growth remains solid, with retail sales growth rising 10.0% year over year in October, and contributing 73% to China’s growth in the first half.

Amid China’s transition, we focus on opportunities stemming from its steady capital account opening, and transition toward the “new economy” and consumer services.

First, as the government steadily opens its capital account through programs like the Shenzhen-Hong Kong Connect, we believe that small and medium-size Chinese com-panies listed on the Hong Kong Exchange (H-Shares) could benefit as onshore capital seeks diversification. As capital is diverted from the domestic property sector and toward overseas assets, however, investors should avoid credits of China’s bank and

“ When it is obvious that the goal cannot be reached, don’t adjust the goal, adjust the action steps.”

– Confucius

180

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20

14

20

15

140

240

260

China’s debt will continue to rise in 2017

Source: Bloomberg

China total-debt-to-GDP (%)

120

Fig. 7


property companies, in our view. We expect the Chinese yuan to continue to depreciate in 2017, forecasting USDCNY at 7.00 in 12 months’ time.

Second, we invest in companies that bene-fit from the changing composition of China’s growth. Tertiary industry (services, excluding financials) is now larger than the secondary industry (manufacturing), and sectors like healthcare, tourism, internet, and entertainment are likely to grow at above-average rates in the years ahead as this trend continues.

Finally, in light of the new US presidency, we focus on domestically-oriented sectors that could fare better amid concerns about global trade, or if the Chinese government looks to stimulate demand. These sectors include select consumer staples, telecoms, healthcare, and internet.

7

7.5

6.5

52013 2014 2015 2016 2017F

6

8

We expect growth to slow, but remain stable

Source: UBS

China GDP growth (%)

5.5

Fig. 8

In shortChina is still trying to balance growth with necessary economic reforms. The former will take precedence in 2017, we believe, and demand will remain stable even if debt keeps rising. Opportunities lie in H-Share mid-caps, and sectors like healthcare, tour-ism, internet, and entertainment.

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Question 7

Does the future of Europe matter for markets? The UK has yet to formally trigger its EU exit, and German and French elections loom. Amid political uncer-tainty, weak growth, and muted earnings, there may be better options for inves-tors than Europe in 2017.

Events in the EU have shaken global mar-kets in recent years. The Eurozone debt crisis in 2011, the fears of a Greek exit from the Eurozone in 2015, and the surprise “Brexit” vote this past summer all intensi-fied global market volatility.

As we look ahead to 2017, the European political calendar again looks packed. The UK is set to trigger “Article 50,” signalling a two-year countdown to leaving the EU, in the first quarter. The Netherlands holds elections in March, France follows in April and May, and German elections will be at some point between August and October. As discussed in The end game? (page 12), politicians may now be more incentivized to pursue populist policies, and years of sluggish growth and the recent migration crisis have shifted the political center ground. Brexit was the clearest example of this phe-nomenon, but right-wing parties in the Netherlands, France and Germany (Party for Freedom, the Front National, and AfD) have also gained popularity in opinion polls, her-alding the potential for further political uncertainty.


So, should investors fear Europe again in 2017?

In our view, whether political uncertainty feeds through into market turmoil depends on:

a) Economic performanceb) The impact of uncertainty on corporate

profitsc) The potential impact on the banking

system

The upcoming elections are unlikely to alter the economic outlook. Underlying growth is fairly solid, although the waning impact of European Central Bank (ECB) stimulus and some drag from the lack of clarity about the Brexit negotiation process mean that we expect the Eurozone eco-nomy to expand at 1.3% in 2017 vs. 1.6% the year prior.

Elections also typically don’t have meaning-ful short-term repercussions on overall corporate profitability. Individual sectors or countries might react to adjustments in tax rates, regulation, or trade terms, but investors, provided they are well-diversified, should not see the earnings capacity of

their holdings markedly reduced by a chang-ing of the political guard. That said, the underlying picture for corporate profitability in the Eurozone is relatively muted at pres-ent, largely due to weak growth in the financial sector, which is still suffering from negative interest rates, weak loan demand, and a relatively high share of non-performing loans.

The elections could, however, be more consequential for the region’s banks. ECB actions have managed to contain political fallout – bank credit spreads have actually narrowed since the UK’s Brexit vote. But

“ The problem is when two govern-ments in Europe hold differing opin-ions, it is immedi-ately a crisis.” – Jean-Claude Juncker

In shortElections will take place in the Nether-lands, France, and Germany in 2017. Amid a slowing economy, muted profit growth, and political uncertainty, we see better places to invest than Europe in 2017. Within the region, we focus on companies that earn a high share of their profits from emerging markets.

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favorable showings for France’s Front National in particular could raise jitters about the European banking sector, given that even the possibility of a Eurozone country considering leaving the EU would lead to fears of potential asset-liability mis-matches for the region’s lenders.

Political uncertainty, combined with muted economic and profit growth, means that we currently see better places to invest than Europe (see Top 10 ideas for 2017, pages 45–73). For investors with a long-term al-location to Europe, we suggest focusing on companies that transact a high per-centage of their sales in emerging markets (page 51) or those returning cash to share-holders through dividends and buybacks (page 58).

Question 7 – Does the future of Europe matter for markets?

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Anti-establishment parties are gaining popularity in Europe

Source: National election results

% of votes won

Freedom Party (Austria)Five Star Movement (Italy)Front National (France)Swedish Democrats (Sweden)Syriza (Greece)AfD (Germany)

Podemos (Spain)Finns Party / True Finns (Finland)

Danish People’s Party (Denmark)

UKIP (UK)

Fig. 9

Industry Leader InsightClient entrepreneurs from the UBS Industry Leader Network recently gathered to discuss risk scenarios that have potential to impact their business.

They identified the migration crisis in Europe as a key risk. Participants concluded that a contin-uation of refugee flows from Syria seems likely, and that the EU-Turkey refugee deal is vulnerable to collapse. Increased migration into Germany, in an election year, could affect Merkel’s re-election prospects, bringing poten-tial political disarray to Germany and the wider region, to the benefit of populist politicians around Europe.

1. US equities

2. EM equities

3. EM FX basket

4. APAC REITs

5. Dividends and buybacks

6. US senior loans

7. US TIPS

8. Palladium and platinum

9. Alternatives

10. Sell high grade bonds

Top 10 ideas for 2017

” The human animal differs from the lesser primates in his passion for lists.” – H. Allen Smith


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Economic growth has room to run Leading indicators in the manufacturing and services sectors imply increased activity ahead, which should mean higher revenue and earnings growth for US corporations, especially as the hindrances from the oil price and strong US dollar diminish. CIO expects US earnings per share to increase 8% in 2017. Any potential fiscal stimulus under the new US leadership could support the economic backdrop further.

Monetary policy will likely remain accommodativeInflation is firming, but remains comfortably below the US Federal Reserve’s target. While the Fed will likely raise borrowing costs (CIO expects a hike in December, and two more next year), it is under no pressure to hike rates aggressively and put the expansion at risk. Financial conditions for businesses and consumers look set to remain accom-modative.

Valuations are not stretched While absolute valuations for US stocks, such as price-to-earnings (P/E) multiples, are slightly higher than average, they are not stretched, and are justified by low infla-tion and durable growth. Historically, P/E multiples tend to rise when interest rates increase from low levels. Finally, equity val-uations look attractive relative to bonds.

Idea 1

US equities Despite a huge rally from the low of 2009, we believe US equities remain in a good position to continue their rise in 2017.

US Technology. Growth may pivot from the consumer to enterprise seg-ments, as businesses look to invest. We prefer the software sector, as valu-ations do not appreciate the sustain-ability of subscription-based revenue models that accompany technologies like cloud computing. Accelerating earnings-per-share growth, attractive relative valuations, and ongoing cash distribution to shareholders are sup-portive for next year. Demand for soft-ware that protects against cyber- attacks may also continue to rise over the long term.

1

US Financials. Firmer US inflation and growth readings should push up the long-term interest rates. With huge sums of cash on the sidelines, banks have not had to raise deposit rates despite higher fed funds rates. A larger difference between bank deposit rates and longer-dated assets should support profitability. Capital markets activity is improving and valu-ations look attractive. And looser reg-ulation under the new US govern-ment could further support the sector.

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2016

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8

16

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12

18

Stocks are cheap relative to bondsin a historical context

Source: Datastream

US 10-year bond yield (%)

S&P 500 dividend yield (%)

S&P 500 dividend yield and 10-year bond yield

in %

Fig. 10

US Healthcare. We expect the sector to advance as fears of stricter drug pricing regulation abate after the US election. Pharmaceutical stocks should benefit from better product pipelines, diverse revenue sources, and attractive valuations that do not reflect our expectations for mid-to-high-single-digit percentage earnings growth.

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Idea 2

EM equities After years of underperfor-mance versus developed markets (DM), EM equities have outperformed so far in 2016. Political uncertainty could drive short-term volatil-ity. But CIO thinks EM stocks can con tinue to perform next year.

Regional growth rates should speed up next year.Leading indicators of economic activity, such as purchasing managers’ indices, have reflected four months of EM expansion to October 2016.

The EM growth pickup is not just a function of middle-class domestic demand growth. Terms of trade have improved and commod-ity producers should benefit from stable or rising commodity prices – CIO forecasts Brent prices climbing to USD 60/bbl next year.

2

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Investors are currently under-allocated to emerging markets

Source: EPFR, IIF; *includes mutual funds and ETFs;non-valuation adjusted

Portfolio equity weight

UBS recommended weight (SAA balanced)

% of global equity fund allocations

Fig. 11

Low global interest rates mean abundant liquidity in EM nations. Global interest rates look set to stay low next year. CIO does expect the US Federal Reserve to hike rates twice and the Europe-an Central Bank to reduce the scale of its bond-buying programs. But loose monetary policy will be tightened only gradually. And the premium that EM firms pay to issue investment grade debt remains close to two-year lows.

CIO also expects the US dollar to fade in value as investors price in a gradual pace of US interest rate increases. That matters for EM companies, many of whom generate sales in local currencies but service debt in dollars. A softer USD next year would effec-tively cheapen debt and offer a potential boost to corporate earnings.

EM(U) Winners. We expect Eurozone stocks with exposure to emerging markets to outperform the broader MSCI Europe Index in the year ahead. Our favored stocks have at least 20% EM exposure, the potential for supe-rior earnings growth, and may exhibit lower price volatility than direct EM exposure. After five years of declining EM currencies that reduced the euro value of repatriated profits, EM cur-rency effects no longer constitute a significant earnings hurdle for Euro-zone firms exposed to developing nations. Earnings for EM-exposed Eurozone firms have been picking up, and we expect stock prices to begin to reflect this improvement.

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Earnings per share growth is rising, backed by sustainable fundamental drivers.The earnings of developing market firms are finally growing again, after falling by one-third since 2012. From the trough in February, EM profits had climbed by 8%. And the revisions ratio (a measure of earnings upgrades versus downgrades from company analysts) has rebounded from –40% to a balance of positive and negative revisions.

Investors should monitor the evolution of US trade policy under the new government, but at this stage we believe that EM funda-mentals are strong enough to win out against uncertainty.

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Analysts are growing more positiveon emerging market earnings

Source: Datastream, UBS as of November 7, 2016

Earnings revisions ratio (up-down) / (up+down)

–40

Fig. 12

in %

Idea 3

EM FX basket Emerging market (EM) currencies were among the big winners in 2016. Yet we believe the coming year is set to be another positive one for select EM foreign exchange.

Political uncertainty could create volatility for emerging market currencies in the near term. But the low-yield environment remains supportive, and valuations are attractive. We recommend an overweight position on a basket of EM currencies – including the Brazilian real, the Indian rupee, the Russian ruble, and the South African rand, equally weighted – versus a basket of equally weighted developed market (DM) curren-

cies – the Australian dollar, Canadian dollar, and Swedish krona.

Our selected EM currencies offer a substantial interest rate carry. At the time of writing, this rate advantage is around eight percentage points. Brazil has the highest yield in our group, with three-month rates at 12%, while even the lowest rate – in India – is 6%. In contrast,

3

54 ubs.com/cio

DM rates are still ultra-low. For our DM funding basket, the yield is just 0.6%.

The risk of a significant depreciation for these EM currencies is contained. While these currencies rallied in 2016, they are still significantly down over the past five and 10 years. Since 2006, our EM basket has depreciated 60% versus the US dollar. That has left these currencies close to what CIO believes is fair value. Meanwhile, they are benefiting from a turnaround in the economic outlook. In 2016, purchasing managers’ indices climbed above the 50 mark separating expansion from contrac-tion. Commodity prices also moved higher, helping the outlook for growth. We expect both the Russian and Brazilian economies to expand again in 2017 after deep reces-sions.

Diversification limits the risk that politics will get in the way. In The end game? (page 12) we highlight-ed the influence that policy can have on markets. Russia, Brazil, and South Africa have all been prone to political turbulence in recent years. But the chances of setbacks hitting all of these countries simultaneously is lower. As ever, diversifi-cation is a prime investor tool.

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A select emerging market vs.developed market currency basketwould have delivered stable returns

Source: UBS

Relative yield (LHS, %)

EM/DM Basket return (indexed, RHS)

Fig. 13

Idea 3 – EM FX basket


Relative trade: Investors can protect against EM volatility by pairing with select DM currencies. EM currencies would likely decline if commodity prices and/or global growth declined, but so would the currencies of commodity-reliant developed nations such as Canada and Australia. Sweden’s krona, meanwhile, is highly correlated to global growth. As a result, using this select basket of developed market currencies to fund the trade should reduce the overall risk of the position.

What’s more, we expect the central banks of these countries to be sensitive to a strong appreciation of their currencies, reducing the potential downside of the position even more.

Investing in emerging markets is risky. EM currencies would face risks if global growth slows, or protectionism rises. But through this currency basket pairing we have attempted to reduce downside, and we expect 2017 to be another positive year for EM currencies.

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Idea 4

APAC REITs Central banks are likely to err on the loose side of monetary policy, even if it comes at the cost of higher inflation. One sector that looks likely to benefit from this trend is real estate investment trusts (REITs) in Asia-Pacific.

The asset class offers attractive yield pickup in a low-rate world. REITs, in our view, are bond-like proxies that still offer relative value for yield-seeking investors. Yield spreads to government bonds in Singapore (450 basis points) and Hong Kong (400bps) compare favorably with the global average of 306bps as we went to print. And we expect the continued demand for yield to drive this spread low-er, supporting REIT prices.

Asia Pacific REITs can offer both stable dividends and growth potential.REITs provide greater dividend certainty in an uncertain economic climate where earn-ings uncertainty puts some dividends at risk. In fact, Asian companies this past year have reduced their dividend payments slightly, so this consideration matters.

The current environment of lower-for-longer interest rates and muted economic growth should favor quality, well-capitalized REITs with sustainable dividend yields. In our

selection we focus primarily on Singapore (dividend yield of around 4.1%), Hong Kong, and Australia. Although in the very near term property fundamentals in Hong Kong are weak, Hong Kong REITs comprise a rel-atively small share (12%) of the APAC REITs index.

Valuations remain attractive.Forward yield spreads, a gauge of whether a REIT is cheap or expensive, stood at 5.2% at the time of writing (November), com-pared to a “risk-free” benchmark rate of just 2%. The 3.2% spread, or gap, between these two yields, was above the long-run average of 2.9%.

A quest for higher-yielding assets may lead investors to commit capital to Asia Pacific REITs, driving prices higher and lowering this yield spread toward the long-run mean. A 0.3% decline in the yield spread over a six to 12-month investment horizon would translate into a potential 10% total return. We even see scope for spreads to under-

4

shoot the average, with possible upside for investor returns.

There are potential risks to consider. If the US enacts a substantial fiscal stimulus pro-gram, or the Fed turns hawkish and raises borro wing costs more aggressively than we currently expect, interest rate-sensitive REITs may underperform. And structurally lower rents or higher operating costs could pressure dividend payments.

Yet on balance, the outlook for this asset class looks attractive. The Fed might hike rates in 2017, but interest rates are still below inflation and we believe outperfor-mance of Asia Pacific REITs will extend into the coming year.

3

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Yields across APAC REIT markets look attractive relative to risk-free rates


Risk free rate (%)

Index yield spread (%)

Fig. 14

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Idea 5

Dividends and buybacks Bond yields are ultra-low in Switzerland, the Eurozone, and Japan. Companies offering a reliable income stream there have become even more appealing.

Many investors have historically looked to bonds for income and to equities for capital appreciation. But in an ultra-low yield world, bonds are no longer offering sufficient income. This is particularly so in Switzerland, the Eurozone, and Japan. In the Eurozone, 51% of government bonds now have a negative yield, 77% in Japan, and 85% in Switzerland.

The good news is that some stocks can help plug the income gap. For 2017, we believe that income investors can look to select equities in the Eurozone, Switzerland, and Japan as a fixed-income alternative. CIO favors stocks offering sustainable pay-outs and above-average dividend growth.

5

In the Eurozone: Dividends have always been an important part of investor returns, accounting for about one-third of long-term returns on the MSCI EMU. But the role of dividends has increased in a low-yield environ-ment. As of early November, while 10-year government bond yields were barely above zero, the MSCI EMU equity index was offering a dividend yield of around 3.7%. This gap hovers near an all-time high. And our Euro-zone dividend growth stock selection carries an even higher dividend yield on average. Assuming relatively shareholder- friendly policies, and steady economic growth, these com-panies should be able to continue to raise their dividends.

In Switzerland: The Swiss equity market offers a dividend yield of over 3.5% for the SMI Index. This figure compares to bond yields of well below 1% in the corporate Swiss-franc fixed income market. Here, too, CIO has identified select stocks that offer a combination of dividend sustainability and dividend growth, at a time when Swiss companies are reporting histori-cally low indebtedness and robust profitability.20

30

10

0Stock price appreciation Total return

40

90

20.2

80

70

60

50

100

Dividend growth matters

Source: FactSet, UBS

Above-average dividend growers

Below-average dividend growers

Mean stock performance and total return of the 73 continuously listed dividend-paying Swisslarge-caps since 2006. All stocks equally weighted.

92.2

53.563.1

in %

Fig. 15

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CIO is not positive on these three equity markets overall, but their earnings outlook should be stable enough to support contin-ued high payouts from the companies we identify. In a low-yield world, dividends rule.

In Japan: Japanese companies are awash with cash. Their cash on hand is at historical highs, while their debt-to- equity is at a 15-year low. Traditionally, they have been notorious for meager dividend payouts. But this is chang-ing. The new Corporate Governance and Stewardship Code has been pro-moting more shareholder-friendly pol-icies. The shift toward buybacks, spurred by more assertive investors and pressure to dissolve cross-share-holdings, and raise return on equity, is already underway. As of November, Japanese buyback programs had increased 17% on the previous year. We believe investors can benefit by investing in stocks executing, or in a strong position to execute, buyback programs. Companies that have announced share buybacks have out-performed the market by over 30% since January 2012.

Idea 6

US senior loans Amid decent economic growth, inflation picking up, and the Fed likely to increase rates, we believe US senior loans are among the most appealing segments of fixed income in 2017.

A standout performer in fixed income markets for 2016 was US high yield, which appreciated 13% in the first 10 months of the year. This impressive run has left these assets looking less attractive. Senior loans appear likelier to shine in 2017.

Senior loans are attractive in an envi-ronment of low fixed income yields. Ranging between 5–6%, the yield on senior loans constitutes a pickup of 4% over short-maturity investment grade corporate bonds. Even if we assume a rise in default rates from the current 2% toward the long-term average of 3%, we can expect senior loans to deliver a 3%–5% return.

6

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Idea 6 – US senior loans

Coupons can adjust upward, providing protection against higher base rates.This floating rate feature reduces the dura-tion risk of senior loans. The standard senior loan is benchmarked against three-month USD LIBOR, and its coupon rate is reset every 45 to 60 days on average. There is a minimum floor for resetting – on average at 98 basis points on LIBOR. Once that level is breached, however, senior loan coupons track interest rates higher. With the Fed foreseen to increase interest rates in December and twice in 2017, we expect demand for this asset class to increase.

Credit risk is lower than for high yield bonds. Overall, we are upbeat about the outlook for the US economy and corporations. Our forecast is for earnings per share to grow by 8% in 2017, from an estimated 1% in 2016. Even so, the US credit cycle is relatively mature, so investors should monitor the risk of higher defaults. While default ra tes for senior loans have historically mirrored those of high yield bonds, recovery rates are higher, since senior loans are often secured against a firm’s assets and rank senior in the capital structure. Over the past 20 years, the average annual credit loss on senior loans was 1.3%, less than half the 2.8% loss on high yield bonds.

Senior loans explained. The asset class consists of sub-invest-ment grade bank loans made to companies, and possesses se veral distinctive features – including a float-ing interest rate and a claim on a firm’s assets in the event of default. Senior loans are traded “over the counter,” making them less liquid than some other fixed income assets. US loans have had annualized volatility of 6.8% over the last 15 years, compared to 9.8% for US high yield and 14.7% for US equities. In addition, they have a low correlation to other asset classes, improving diversification.

3

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–1US

loans

5.9

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–0.2

Euroloans

USinvest-mentgrade

Euroinvest-mentgrade

Swissfranchighgrade

1

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Yield pickup in senior loans

Source: BAML, Datastream, UBS

Current yields (%)

0

2.4

4.7

Fig. 16


Idea 7

US TIPS There are signs that inflation is rising. The inflation- protected securities market is under pricing the risk of further increases, in our view.

Investors typically view inflation as a threat that erodes the real value of their assets. But we believe that it will be possible to profit from acce lerating inflation in 2017.

Here’s why:

There is limited slack left in the US jobs market, which should presage higher wage growth. US unemployment is now back to pre-finan-cial crisis levels, with average hourly ear n-ings already having started to rise in the summer of 2016. Along with higher sala ries, such wage increases typically translate into higher discretionary spending and pro-mote a broader increase in prices.

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Low US unemployment iscontributing to higher wage growth

Source: Bloomberg

US Average Hourly Earnings All Employee

1.5

Fig. 17

7

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The oil price appears to have stabi-lized, removing a key downward force on inflation.The value of a barrel of Brent fell 75% from mid-2014 to its low point in February 2016. This plunge contributed to repeated downside surprises in consumer price index (CPI) readings. While oil only accounts for around 6% of the overall price index in the US, it has an outsized effect on inflation perceptions. Through 2017 we expect the global glut in oil supplies to clear, allowing the price of Brent to rise modestly to USD 60/bbl over the coming 12 months. The base effects of steadier oil are likely to push inflation up in the coming months.

Donald Trump’s platform has an infla-tionary bias.His fiscal policy is likely to be expansion-ary, and he leans toward protectionism, which is inflationary due to the effects of tariffs and curtailed immigration.

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today

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Oil base effects will contribute to higher inflation in the months ahead

Source: Bloomberg

Year-over-year change in WTI, (assuming flat prices)(%)

–40

Fig. 18


Relative trade: Investors can invest more purely in rising inflation expec-tations by offsetting a long position in Treasury inflation-protected securi-ties (TIPS) with a short position in nominal Treasury bonds. Funding TIPS purcha ses with nominal Treasuries entails lower risk than funding with cash. Such a relative trade features limited duration exposure, though unexpec tedly aggressive Fed tighten-ing could cause it to underperform. Still, that outcome looks unlikely given the emphasis being placed on gradu-alism by top monetary officials.

We expect a weaker US dollar to boost import prices, an additional spur for price rises. The US currency has climbed by 25% since mid-2014, according to the Bloomberg Dollar Spot Index. This currency strength has been dragging down the price of imports. As the US dollar has stabilized recently, import prices have started to climb. CIO expects dollar weakening in 2017 given the current overvaluation of the US dollar.

In addition, statements from top Federal Reserve officials, including Chair Janet Yel-len, suggest that the Fed is willing to toler-ate inflation slightly above its 2% target. In late 2016 Yellen indicated that the Fed could consider running a “high-pressure economy” for a while to draw more discour-aged workers back into the labor force.

CIO believes that the best returns from this trade can be achieved by focusing on TIPS with a duration between three and seven years. Inflation expectations embedded in shorter-duration securities tend to be more volatile and are already pricing in a more significant uptick in inflation. The long end of the yield curve, by contrast, is less liquid.

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Idea 8

Palladium and platinum A pickup in industrial activity, political uncertainty and falling real interest rates should support palladium and platinum in 2017.

Gold and silver were surprise winners in 2016. Political and financial uncertainties throughout the year – whether over the Chinese economy, the UK’s Brexit vote, or the US election – ensured high demand for “insurance assets” like gold.

We think precious metals can perform well again in 2017. But we focus on the industri-ally oriented precious metals palladium and platinum.

Industrial activity is picking up, increas-ing demand for palladium and platinum. Investors mostly shunned the two metals in 2016, given weak manufacturing and industrial production data in the first half of the year. But the overall outlook for indus-trial activity looks more promising in the year ahead, with PMI readings moving comfortably over 50 in much of the world. Demand for platinum and palladium in auto catalysts, which turn noxious gasses into less harmful substances, is growing –

8

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2011 2012 2013 2014 2015 2016

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Rising car sales should boost platinum and palladium demand


Year-on-year change in %, 3-month moving average

0

Fig. 19

due to rising sales of light and heavy-duty vehicle sales in China and Europe, and tighter emissions standards. We also expect jewelry demand for platinum to expand again in China, supported by its lower retail price relative to gold.

Both white metals are in short supply, partly due to contracting mining activity.We have seen a period of underinvestment stemming from low prices. Inventories held by producers are also low, so it is unlikely that stocks will be able to bridge the gap between restricted supply and rising indus-trial demand.

Real interest rates are likely to stay low.Rising rates, or opportunity costs, are a lead-ing enemy of precious metals, which offer no yield or dividend. So higher interest rates from the Fed represent a potential negative for gold and platinum at first glance. But we believe that real interest rates matter most, and US rate hikes will likely lag a pickup in inflation. With real rates remaining low in the US, precious metal prices should be well supported.

For investors looking to buy palladium and platinum, we believe a small allocation to gold reduces the risks associated with this trade. If global growth fails to meet our forecasts and dents industrial demand, gold would stand to gain, while palladium and-platinum would come under pressure.

Based on continued easy monetary policy from central banks, ongoing political uncertainty, and improving industrial demand, this precious metals basket is one of our top trade ideas for 2017.

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Idea 9

Alternatives Hedge funds and private markets will be critical parts of investor portfolios in 2017. Traditional asset class returns are likely to be moderate, and uncorrelated exposure will be more valuable than ever.

Hedge fundsWe believe that hedge funds represent a crucial part of well-balanced portfolios, and currently recommend allocations of 16%–20% for most investors. In an environ-ment where low yields will likely mean that returns for bonds are low, we expect hedge funds to provide an attractive alternative, with low correlation, higher returns, down-side protection, and only mo derate risk.

In 2017 we expect performance to be boosted by:

• Steady increases in US interest rates Hedge fund strategies have historically performed well during periods of rising interest rates. The HFRI Fund Weighted Composite Index returned close to 12% p.a. on average during the past three US rate-hike cycles. Although this kind of performance is unlikely to repeat itself, it demonstrates that hedge funds are capa-ble of strong absolute and relative perfor-mance during periods of rising rates.

• Rising equity markets Hedge funds have a small positive beta to equity markets, and should stand to gain if the equity market moves higher, as we expect (see page 97).

• Higher stock dispersion and normalizing volatility As the equity market rally matures, stock fundamentals are becoming more import-ant for price performance, providing equity long-short managers opportunities to generate alpha.

We anticipate returns of 4–6% in 2017 for the asset class as a whole.

A well-diversified portfolio investing in a range of managers and styles remains the best approach to hedge fund investing. For instance, in 2016, diversifying a hedge fund portfolio using systematic traders would have significantly improved risk/return characteristics as the strategy performed positively when other hedge fund styles

9


suffered. As a stand-alone investment, however, the strategy ranks among 2016’s low-tier performers.

The hedge fund industry has suffered out-flows recently, partly because of fund-of-fund redemptions and partly due to the rise of smart beta exchange-traded funds. We think the outflows create a unique oppor-tunity for private investors to increase their allocation to hedge funds and to put it in the hands of top-tier managers.

Private marketsFor investors with a limited near-term need for capital, 2017 could also be a good year to explore private market strategies.

Public equity listings seem to be going out of fashion: the number of US-listed compa-nies has roughly halved since its peak in 1996. Firms, in particular many of the fast-est growing technology companies, are staying private for longer. Globally, there are now 177 private companies valued at

Alternatives are a crucial part of a well-diversified portfolio

Source: UBS

Equities/bonds

Alternatives

CIO strategic weighting to alternatives for most risk profiles

80–84%

16–20%

Fig. 20

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USD 1bn or more, according to CB Insights. Gaining diversified exposure to the firms driving the global economy now requires investors to have at least some exposure to private markets.

These strategies also provide investors with additional potential sources of return, including an illiquidity premium for locking up capital, which are important in a low yield environment. They expand the num-ber of investment options available to include illiquid companies and assets: managers of private market funds can capitalize more easily on mispriced assets thanks to their long-term perspective, locked-up investment capital, and ability to uncover relevant information not as readily available to average investors.

In a low-return world, manager selection is particularly important, given that the per-formance difference between the top and bottom quartile of private equity funds is far wider than it is for equities and bond funds, and can exceed 20%. Access to top-tier private equity managers is equally import-ant, since they can create significant value in their portfolios’ companies by utilizing industry knowledge, optimizing capital structures, and sharing best practices across those companies.

We continue to expect long-term returns of 8.5–12.0% for investors who maintain consistent allocations to private markets diversified by strategy, region, and vintage year.

Idea 9 – Alternatives

Idea 10

Sell high grade bonds Yields are negligible and the risks to high grade bond positions are rising. Inves tors could consider replicating some of the insurance fea-tures of the asset class with other assets or approaches.

10

The risks to high grade holdings are rising. Inflation is starting to pick up, now at a two-year high in Europe and the US. Increased fiscal stimulus under Republican leadership could lead to even higher infla-tion expectations. And if economic growth surprises to the upside, there is an

outside risk that the Fed would be forced to increase rates more aggressively than we currently expect, or that the European Cen-tral Bank could be forced to taper its quan-titative easing program. High grade bonds offer little cushion against rising interest rates or against longer-term inflation risks.

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The alternatives to high grade.Some allocation to high grade bonds makes sense for most investors, but to prepare portfolios for the challenges of today, we see a number of potentially attractive alter-natives:

• Switching out of bonds with a high probability of negative return. It is important to hold high grade bonds in a portfolio. But this doesn’t mean investors should hold bonds with a very high probability of delivering negative returns. Investors should look to switch out of short-duration bonds with a deeply negative yield-to-maturity, and longer-duration bonds which are particu-larly vulnerable to interest rate rises.

• US inflation-protected securities. Inflation is an important risk for high grade bonds – both making the nominal value of the principal and coupons lower, as well as increasing the risk of interest rate hikes. Investors looking to mitigate inflation risk, but remain invested in high quality bonds, could consider infla-tion-protected bonds. Treasury Inflation Protected Securities are one of our Top 10 Ideas for 2017 (see page 63), as we believe the market is under-pricing the risk of higher inflation.

Idea 10 – Sell high grade bonds

Close to 40% of global government bonds have a negative yield

Source: Bloomberg

Less than –0.4%

Between –0.4% and 0%

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Fig. 21


• Alternatives. Those with a higher risk appetite looking for both return and portfolio diversifica-tion could also consider alternatives, such as hedge funds, as a bond alternative. At turning points in monetary policy, cor-relations between bonds and equities can rise, reducing the diversification benefits provided by high grade bonds. Alterna-tives offer a third source of return which may be relatively less correlated than bonds and equities during times of mar-ket uncertainty about monetary policy (for more, see page 68).

• Systematic hedging. Those holding high grade bonds as pro-tection against sharp drawdowns in equity markets, but uncertain about interest rate rises could consider a Syste-matic Hedging approach. By systemati-cally buying insurance on less-widely traded markets, investors can reduce their risk of sharp portfolio drawdowns while reducing the cost of insurance.

• Systematic allocation. Investors looking for the security of bonds when markets are volatile but the upside of equities when markets are more calm could consider a systematic allocation approach, using quantitative signals to allocate to equities when the market backdrop is supportive, and reduce equity exposure when conditions worsen (for more, see page 90).

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Long-term investmentsAmid political risk, muted growth, and volatile markets, investors might rightfully be feeling fatigued by the financial news cycle. Long-term investments could provide some respite.

While no investor can afford to ignore cur-rent events, CIO believes that portfolios can benefit from multidecade trends, such as urbanization, an aging global population, and the rise of an affluent middle class in emerging markets. Such trends are likely to persist whatever the outcome of any elec-tion or central bank decision, and do not depend on the timing of the economic cycle.

In this Year Ahead publication, we highlight just three:

• Emerging market healthcare catch-up As developing nations become wealth-ier, spending on healthcare is far out-pacing their GDP growth. That is creat-ing numerous opportunities for private companies.

• Energy efficiency Saving fuel can be as lucrative as pro-ducing it. Governments around the world are increasing incentives to cut down on carbon emissions and lower energy consumption. Such standards now cover 30% of fuel used world -wide, up from 11% at the turn of the millennium.

• The education gap Governments are struggling to keep up with soaring demand for higher educa-tion and training. That need is being filled by the private sector. Roughly three-quar-ters of university students in Brazil study at for-profit institutions. And there are opportunities in emerging and develop-ing nations alike.

These articles contain views which originate from persons outside CIO Wealth Manage-ment. These persons are not subject to all legal provisions governing the independence of financial research. The “Directives on the Independence of Financial Research,” issued by the Board of Directors of the Swiss Bank-ers Association (SBA), do not apply.

Hear from entrepreneurs in these fields at: www.ubs.com/globalvisionaries


Education

Emerging market healthcare

Energy efficiency

“ Trees that are slow to grow bear the best fruit.” – Molière


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Marieme Jamme’s mission is to rescue what she calls the “missing millions” – young girls who don’t have access to education or training. A successful African tech entre-preneur, she also founded iamtheCODE, an academy that teaches computer pro-gramming to vulnerable young girls. Hav-ing been trafficked to Europe at 15 years of age to work as a prostitute, Jamme believes she could have avoided this fate if such educational opportunities had been offered to her.

“ We’re looking to bridge the gap the government is simply not filling,” she explains.

The shortfall Jamme identifies is a global one.

In emerging markets, an expanding middle class is becoming ever more aware of the economic rewards offered by education. In Brazil, for example, a university graduate can

expect to earn around 130% more than a less educated peer, according to data from the OECD. (The average premium for rich nations is a more modest but still hefty 48%.)

“ This large wage advantage appears to stem partly from the relatively short supply of college graduates in many developing nations,” says Daniel Sanchez Serra, an OECD

education analyst.

While nearly two-thirds of US citizens attended college as of 2013, just 31% of Brazilians did and 19% of Indians. That leaves plenty of room for catch-up, especially as climbing incomes mean that more peo-ple are able and willing to pay for school-ing. For example, the percentage of family income devoted to education rose 13-fold in China between 1985 and 2012, figures by Xueda show.

EducationGrowing demand and new means of learning are opening up opportunities for private companies.


The changing face of educationMeanwhile in developed nations, a more fluid employment market encourages work-ers to continue training long after finishing formal education. US workers under 32 years of age typically change jobs four times in their first decade in the labor market, twice the amount of career switching of the previous generation, according to a 2016 LinkedIn study. In addition, advances in technology, including robotics and artificial intelligence, can be expected to displace more workers in coming decades, encour-aging a greater number of them to acquire new skills.

Globally, demand for education and training is growing at roughly twice the pace of economic output. That has left govern-ments struggling to keep pace, especially at a time of high fiscal deficits and rising debt in many countries. Increasingly, the spending gulf is creating opportunities for corporations.

“ Governments are still the dominant force in basic educa-tion. They ensure that their citizens have basic literacy and numeracy, and in many cases enable them to pursue higher academic education,” says Hyde Chen, a strategist in UBS’s Chief Investment Office.

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finance basic education in low-income countries

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Global education financing gap

Source: UNESCO – Education for All Global Monitoring Report; Youth and Skills: Putting Education to Work, (UNESCO, 2012).

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USD bn

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Long-Term investments – Education

“It is in the areas of professional training, language tuition, and standardized testing that governments are playing second fiddle to a burgeoning number of private sector firms. And the share of the higher education market that these private firms have is also expanding fast.” In Brazil, for example, increased demand for higher education is partly being satisfied by for-profit firms. Three-quarters of Brazil’s seven million uni-versity students currently study in private institutions.

A technical revolution brings education to the massesTechnology is a major force enabling compa-nies to access an even wider market.

“ The difficulty of getting to a classroom made it unfeasible for many people to acquire education or training, whether they lived in remote areas or because they needed to work during the day,”

“ This constraint on the market

is gradually lifting.” says Gerard Robinson, an education expert at the American Enterprise Institute.


Businesses like Kenya-based OneUni are taking advantage of the near-universal use of cell phones in Africa even among low- income groups. Partnering with regional universities, OneUni provides interactive courses designed for mobile devices.

Meanwhile, online tutorials can reach stu-dents in a more cost-effective way, with a low incremental cost per additional student. This is a potential recipe for higher profit margins. A study by former Princeton Uni-versity President William Bowen found that switching from a traditional college teaching model to a hybrid online format could cut staffing costs by 37%–57%. And that did not include the potential savings from needing fewer buildings on campus.

The efficiencies of this approach can be gauged from the experience of the Khan Academy, a non-profit online tuition provider that serves 15 million users per month on an annual budget of just USD 24m and with a staff of just 100 people.

Marieme Jamme’s iamtheCODE academy has thus far offered a lifeline to 2,000 girls in Africa who have completed her coding course. While she offers such training for free, she believes that private sector educa-tion service providers “could be the savior” for millions more who consider education the key to success.

Hear more about Marieme’s story at www.ubs.com/globalvisionaries

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Twelve years ago, Shaffi Mather’s mother faced a medical emergency. He rushed her to the hospital in the back of his car. “Even if you are wealthy (in India), in an emergency you drive your family member or friend to the hospital. India has ambu-lances, but these vehicles are not equipped with life-support services and or medically trained staff.”

Later, as he waited for his mother to recover in the intensive care unit, he had an epipha-ny. The dearth of emergency care inspired him to found MUrgency, a mobile applica-tion that connects people who need emergency response with a community of medical professionals and their network.

Time to play catch-upMather’s story and MUrgency are part of a wider trend in evolving emerging mar-ket (EM) healthcare systems. After years of neglect, EM governments are now under strain as greying populations and growing affluence conspire to increase

the cost and complexity of healthcare provision.

Hypertension, diabetes, and cardiovascu-lar disease are on the rise as lifestyles become more sedentary and diets include more meat and sugar. “Non-communica-ble diseases are becoming far more pre-valent in developing nations. And these chronic conditions are much more expen-sive to treat than infectious diseases,” says Amanda Glassman, director of health policy at the Center for Global Develop-ment. For example, the US spends an average of USD 90,000 per stroke patient and just USD 5,450 per malaria patient.

Meanwhile, the percentage of people 65 years or older in EM has doubled since 1980 to 10%, and will likely reach 15% by 2030, according to the UN. Older populations entail higher costs. In the EU, public health-care spending as a percentage of GDP aver-ages 15% per capita on those 66 and older, compared to just 5% for 20–65 year olds.

Emerging market healthcareAging, increased prosperity, and even medical tourism are fueling demand for health-care services in emerging markets.


Despite the growing similarity between the healthcare challenges faced by EM and more developed markets (DM), EM spend less than half what DM do on healthcare as a share of GDP. There are just 3.4 hospital beds per 1,000 citizens on average in EM versus 9.5 in DM, according to the World Bank.

EM health spending to outpace GDP growth EM policymakers are aggressively seeking to catch up to their DM counterparts in terms of healthcare quality and accessibility.

“ We expect the EM healthcare sector to grow at an 8% pace annually from 2014 to 2020, double the forecast for overall GDP growth. China and India are expected to post double- digit growth rates,” says CIO strategist Carl Berrisford.

China in particular is spearheading the EM healthcare revolution. It has embarked on the most ambitious healthcare reform programs in history by targeting a seven-fold increase in medical spending from 2011 to 2020. This would imply a 26% compound growth rate over the coming five years, turning China’s healthcare market into an CNY 8trn (USD 894bn) industry and, in essence, doubling the size of the entire EM healthcare sector from today’s valuation. This upsurge in public spending, for exam-ple, aims to increase the number of hospital beds for every 1,000 people from 4.55 currently to 6 by 2020. This is likely to prove a boon for private hospital groups, pharma-ceutical firms and ambulance services.

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1980 1990 2000 2010 2020 2030

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14

16

18

Source: World Health Organization, World Economic Outlook, UBS as of 2013.

Asia

Latin America

EMEA

Fig. 23

(% o

f to

tal)

Emerging market populations are aging rapidly

Population above 65

(percentage of total)

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Traveling farther for healthcareMedical tourism is another potential source of EM growth and opportunity.

“ For people from wealthy nations it can be tempting to take advantage of the lower costs in developing nations, particularly for procedures not covered by insurance firms at home,”

says Amanda Glassman, director of health policy at the Center for Global Development.

Long-Term investments – Emerging market healthcare

Some emerging countries have carved out specialist or low-cost niches. South Korea, for example, has become a regional hub for cosmetic surgery. South Africa offers “safari surgery.” And Thailand offers a combina-tion of quality and affordable services, alongside its famous beaches. In Asia, the medical tourism market doubled between 2011 and the end of 2015, according to industry sources, a trend likely to continue thanks to rising regional income growth, improved healthcare quality and cheaper air travel.

Sputtering economies and weak commodity prices pose a risk for the sector. Both might increase public deficits, curbing govern-mental ability to invest in domestic health-


care. But with healthcare demand almost certain to rise in spite of economic growth, the sector is likely to prove more resilient than others.

And if public sector spending comes under pressure, entrepreneurs like Mather and his company MUrgency have the potential to plug the gap. He has transported more than six million people to the hospital since starting his business in 2004. More of the same from his peers could push the EM healthcare sector from the intensive care unit to the recovery ward.

8

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0

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14

Basic healthcare provision inemerging market lags behinddeveloped markets

Source: World Bank, UBS.

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Fig. 24

Hear more about Shaffi’s story at www.ubs.com/globalvisionaries

A compelling theme for impact investorsGiven acute gaps in affordability, access, and quality, emerging market healthcare is also a compelling theme for impact investors who intend to generate both financial returns and a measurable social impact on the lives of patients and families. Lower relative weightings to healthcare in emerging markets indices mean that many healthcare impact opportunities are found in the private company universe.

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The global appetite for energy seems insa-tiable. Fuel consumption is set to increase almost 50% by 2040, according to the Inter-national Energy Agency, driven by economic growth and a rising population.

Yet the unwanted side effects of energy use are becoming harder to ignore. Air pol-lution contributes to around three million premature deaths a year. The OECD fears the death toll may climb to nine million by 2060. And global warming threatens to weigh on crop yields, water quality, and ultimately global growth.

Confronting these challenges, governments have started to incorporate efficiency targets into their energy strategies: “The default option when countries need more power has been to produce more – often commit-ting to a multi-billion-dollar power plant that would operate for many decades,” says Alexander Stiehler, a strategist for the CIO. “But it can be far more cost-effective to squeeze out waste.”

Energy efficiency: The world’s “first” fuel Aside from helping cut carbon emissions and air pollution, energy efficiency can reduce a country’s dependence on energy produced abroad – a priority for many states in an age of rising nationalism.

“ All of the energy challenges that nations confront can be helped by improving efficiency,”

“ Only some nations have coal or oil, but every country has the potential to exploit efficiency. For that reason it can be considered the world’s first fuel.” says Brian Motherway, head of energy efficiency at the International Energy Agency (IEA).

Energy efficiency

Investment opportunities in energy efficiency are increasing as governments shift from producing more to saving more.


The result of this trend has been a raft of government regulations and incentives that create opportunities for firms to reduce energy waste. The EU, for example, has set itself the goal of becoming 20% more energy efficient by 2020 – which equates to turning off 400 power stations. The BRIC nations are also making a deter-mined effort to reduce their CO

2 emissions

and improve energy efficiency. Russia, for example, announced a few years ago its goal of boosting energy intensity by 44% between 2005 and 2030. Brazil is targeting 10% efficiency gains in the electricity sector by 2030. And China aims to reduce CO

2

intensity per unit of GDP by around 65% between 2005 to 2030. This is part of a global drive. Energy standards now cover 30% of fuel used worldwide, according to the IEA, up from 11% in 2000.

“ Not only are efficiency stan-dards becoming more prevalent, they are getting progressively stronger,”

“ Governments are setting the standards and the private sector is delivering.” says Motherway.

The race to meet regulationEnergy-saving products and service mar-kets are forecast to grow as fast as 7–8% a year in the coming two decades, accord-ing to the IEA. That is a leap in annual spending from USD 130bn in 2013 to USD 550bn in 2035.

Smart grids increase the flexibility and efficiency of the electricity network

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A key focus will be upgrading buildings, which account for 40% of total global energy demand. “There can be incredible waste in commercial buildings, with heating and air-conditioning systems being run on the same day and lights or computers being left on through the night or over weekends,” explains Jim Barrett, chief economist of the American Council on an Energy Efficient Economy. Smart buildings have centralized systems that control these environmental systems. As standards improve, firms that coordinate these processes – turning lights and computers off when the last worker leaves – can realize even greater efficiency.

In the US, it costs just three cents on average to save a kilowatt-hour through energy- efficiency measures, versus around 10 cents on average for electricity generation, according to research by the ACEEE. Nations like Switzerland and Japan, which have limited domestic fuel resources, have been trailblazers here, achieving major efficiency gains that others can emulate.

The road to clear skies Transport accounts for another 30% of global energy demand. The implementation of standards for car fuel economy have already saved the equivalent of 2.3 million barrels of oil a day – approximately the output of Brazil. Yet only about 25% of the energy contained in gasoline reaches the wheels of today’s average vehicle, according to US Department of Energy data. Electric cars, with a conversion ratio near 60%, have the potential to increase transport efficiency even more.

Companies that offer cloud computing services could also benefit from the push for energy thrift. “Instead of maintaining energy-guzzling servers, which are often underutilized, companies can let cloud pro-viders that efficiently pool resources run their IT infrastructure,” says Sundeep Gantori, an analyst for the CIO. Various studies suggest this could more than halve busi-nesses’ energy consumption.

Long-Term investments – Energy Efficiency


Another major challenge is trimming waste when transmitting electricity. ABB estimates that 80% of electricity is lost between resource extraction and final use. Such inefficiency is an even more pressing issue in Africa, where power outages are the bane of businesses. Solar energy can be part of the solution, argues Matthew Tilleard, co-founder of Crossboundary, a solar panel- fitting company in Africa “[Solar] enables firms to reduce their reliance on an ineffi-cient and often unreliable grid, or on highly polluting diesel generators.”

Hear Matthew’s story at www.ubs.com/globalvisionaries

Rich and poor countries alike are already cutting waste. The US economy has grown by 150% over the past 25 years, yet energy use rose just 26%. Global energy intensity – the amount of energy used per unit of GDP – improved by 1.8% in 2015, the IEA calculates. But far more needs to be done. Progress on energy intensity needs to be 50% faster than at present to meet the Paris Agreement goals on climate change, according to the IEA. As governments focus on climate, pollu-tion, and energy- security goals, the appe-tite to invest in companies that help reduce energy waste looks set to increase.

90 ubs.com/cio

Portfolio investingA well-performing invest-ment portfolio is about more than just having good investment ideas, and in a low-yield world, investors increasingly need to consider new means of portfolio construction to deliver sufficient returns.

We believe our Top 10 Ideas for 2017 (page 45) are likely to outperform this year, aided by steady growth in the US and China, cen-tral bank policy remaining relatively loose, and a gradual pickup in inflation. Similarly, our long-term investment ideas should out-perform over the long term, in our view, thanks to the secular growth drivers described on pages 74 to 89.

But investing in just a few ideas is risky. If our base case does not transpire, per-haps due to yet another surprise election result, change in central bank policy (as discussed in The end game?, page 12) or another key risk becoming reality (page 30), some, or all, of our Top 10 ideas could suffer. Similarly, our long-term investment themes could be affected in the short term by volatility. This is why the diversified portfolio approach to investing is so critical.

” Investing is not merely a matter of eggs and baskets. It takes other ingredients to make a good diversified portfolio.”

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Diversified portfolio approachAvoiding concentration risk, avoiding behavioral traps, and reducing short-term volatility are why the concept of the diversi-fied portfolio is at the core of our approach to investing.

By diversifying, investors can improve their returns without commensurately increasing the risk in their portfolios. A long-term stra-tegic asset allocation (SAA) should be a central component of their overall invest-ment strategy, in our view.

Alternatives are an important addition to bonds and equitiesToday, the traditional “stocks and bonds” diversified portfolio approach faces two key challenges. First, bonds and equities are increasingly moving in tandem as we approach a potential inflection point in monetary policy. Second, prospective returns are likely to be lower in the years ahead than we have seen in the recent past, particularly in Europe and Switzerland, where many high grade bonds now have a negative yield.

In recent years, we’ve increased the alloca-tion to alternatives within our model diver-sified portfolios to try and boost returns while reducing portfolio volatility. Most of our model portfolios include allocations to a wide range of equities, bonds and alterna-tives to harvest a range of sources of return, and to help shield portfolios from market shocks.

Searching for higher portfolio returns without additional riskWhile alternatives are both important to and helpful for investors today, they are no panacea. Creativity is also required to enable investors to succeed in their search for higher portfolio returns.

Broadly, this can be done by: a) including a greater range of assets in a long-term portfolio; and b) becoming more opportu-nistic.

Private markets investing: “Endowment-style” approachOne creative approach draws on the successes of leading university endowment funds. In the decade to 2015, the MIT endowment has risen in value by an average of more than 10% annually, with those of Stanford, Penn State, and Harvard all earn-ing in excess of 7.5% per year (according to Bloomberg data).

Portfolio investing


These funds have achieved this performance by weighting their portfolios more heavily in favor of private market investments (including private equity and debt funds) than most traditional allocations held by individual investors. Such an increased weighting, we believe, can improve port-folio returns for private investors with a multi-year investment horizon.

Harnessing illiquidity: Global credit approachFor investors who exclude equities from their portfolios, another approach is to broaden the search for yield into the full universe of credit classes, including assets like mezzanine loans, asset-backed securi-ties, corporate hybrid bonds, and bank capital, alongside more “standard” fixed income asset classes such as senior corpo-rate bonds, emerging market credits, and high yield credits.

The diverse characteristics of the credit universe, in our view, mean that a mix of securities should achieve both diversification and return, without necessarily having to rely on assets like equities to provide growth.

Seeking alpha: Opportunistic approachInvestors could also consider allocating a part of their portfolio to take advantage of opportunistic ideas, such as those mentioned in the Top 10 Ideas for 2017 (page 45). Relative value may also be partic-ularly attractive at this point of the econom-ic cycle. Playing the divergence and conver-gence between assets increases the potential for profits in a world where future outright returns appear likely to be lower than those that have been achieved previously.

The relative value ideas of the CIO Short Term Investment Opportunities team could be employed as a “satellite” portfolio to

96 ubs.com/cio

complement a well-diversified long-term SAA with the aim of boosting its returns. Or investors could trade individual high- conviction ideas to achieve additional return opportunistically.

Avoiding biases: Systematic allocation approachA final approach involves investing dynami-cally, switching between bonds and equi-ties depending on market conditions. One of the key investment challenges investors face relates to the matter of discipline, which this approach structurally integrates as a feature.

Behavioral biases consistently work against investors by encouraging them to wait for more favorable prices to sell or buy assets. This tendency often leads to inertia. One way of overcoming it is by employing risk-management tools, similar to those used by leading institutional investors, to signal when to “buy” or “sell.”

Portfolio investing


Global equities are trading in line with their long-term average valuations. The MSCI AC World is trading on a trailing price-to-earn-ings ratio of 17.0x, above a 10-year average of 14.8.x and below a 20-year average of 18.1x.

Although equities are not cheap in abso-lute terms, they are attractively valued relative to bonds. In the US, the equity risk premium, a measure of relative value, is currently 5.4% versus a long-run average of 3.1%.

EquitiesEquity markets have per-formed well in recent years, but they still have upside, in our view. We prefer US and emerging market equities as we enter 2017.

1415

1213

1011

EM Eurozone US AC World

1617181920

Stocks are trading in line with long-term average valuations…

Source: Datastream

Fig. 28

Trailing P/E (x)

average P/E (20 year, x)

average P/E (10 year, x)

8

10

4

6

0

2

1960 1967 1974 1981 1988 1995 2002 2009 2016

12

…but stocks look cheap relative to bonds.

Source: Datastream

Fig. 29

Equity risk premium (%)

Median since 1960

Note: The equity risk premium is the difference between the earnings yield and the real 10-year bond yield.

98 ubs.com/cio

Equities

We expect US earnings growth of 8%, thanks to continued economic growth as hindrances from oil price woes and the strong dollar finally fade.

We expect an earnings growth rate in the mid-teens for UK equities thanks to a weak pound and rising oil prices, but we note some of this growth is already priced in.

Earnings in emerging markets are turning around. The revision ratio – a measure of analyst upgrades versus downgrades – has rebounded from –40% to an equal balance of upgrades and downgrades.

The strength of the Japanese yen is likely to act as a brake on the Japanese market.

Equities

120

140

80

100

40

60

Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 Mar-13 Mar-15 Mar-17

160

US earnings growth is poised to resume…

Source: Datastream

Fig. 30

S&P 500 (indexed to 2007=100)

EPS (indexed to 2007=100)

20

10

30

–10

0

–50

–30

–20

–40

Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16

40

…and earnings momentum in EM is improving. We are positive on EM equities.

Source: Datastream

Fig. 31

Earnings revisions ratio (up-down) / (up+down)

1000

1200

600

800

0

400

200

2005 2007 2009 2011 2013 2015

1400

120

130

100

90

110

60

80

70

140

Bank of Japan buying should help Japanese equities, but yen strength will weigh on them.

Source: Bloomberg

MSCI Japan (LHS)

USDJPY (RHS)

Fig. 33

2100

1900

2000

1600

1800

1700

Sep-

16

Jul-1

6

May

-16

Mar

-16

Jan-

16

Nov

-15

Sep-

15

Jul-1

5

May

-15

Mar

-15

Jan-

15

Nov

-16

2200140

130125

135

110

120115

145

UK equities should be supported by rising earnings, but the index has already rallied.

Source: Datastream

MSCI UK (LHS)

Earnings per share (RHS)

Fig. 32


We expect Eurozone earnings growth of 5–9%, while consensus anticipates 13%. Without positive economic surprises, earn-ings downgrades could drag down the market.

Healthcare and consumer staples compa-nies comprise 59% of the MSCI Switzer-land Index. This defensive sector mix could leave Switzerland vulnerable to relative underperformance.

2013

Euro

zone

EPS

gro

wth

(%)

–6%

3%5%

0%

5–9%

13%

2014 2015 2016 2017E - CIO

2017E -consensus

10

0

5

–10

–5

15

Earnings expectations in the Eurozone look too ambitious…

Source: Datastream, UBS

Fig. 34

…and Switzerland could underperform, due its defensive sector mix.

Fig. 35

Source: MSCI

Cons. Staples

Healthcare

Other

24%

35%

41%

100 ubs.com/cio

Despite their low or negative yields, high grade bonds proved an important part of a diversified portfolio in 2016, shielding investors when equity markets became more volatile.

Close to 40% of the global government bond market is trading with a negative yield. Selling high grade bonds is among our Top 10 ideas for 2017.

BondsBond yields are historically low, but we see opportunities in US inflation-protected bonds and US senior loans.

2100

2200

1700

1900

2000

1800

1400

1600

1500

Oct-15 Jan-16 Apr-16 Jul-16 Oct-16

2300

0.40.2

0.80.6

2.01.8

1.21.0

1.61.4

0.0

High grade bonds remain an important portfolio diversifier…

Source: Bloomberg

S&P 500 (%, LHS)

US 5-year yields (%, RHS)

Fig. 36

….but yields are exceptionally low.

Source: Bloomberg

0 20 40 60 80 100

Global DM Govt

Eurozone

Switzerland

UK

US

Japan

Less than –0.4% Between 0.5% and 1%

Between –0.4% and 0% More than 1%

Between 0% and 0.5%

Fig. 37


We expect inflation expectations to rise in the US as commodity prices stabilize, unemployment falls, and the US dollar weakens throughout the year.

As an alternative to high grade bonds, investment grade (IG) bonds with medium-length maturities offer a yield pickup of 0.4% with limited extra risk.

Senior loans offer an attractive yield, which exceeds that of short-duration investment grade bonds by close to 4%, and they have a “floating rate,” making them less vulner-able to US interest rate rises.

Investors should be cautious of longer- maturity investment grade bonds as inter-est rates rise. At current yields, almost four years of income would be wiped out with a 1% move in yields.

5-ye

ar U

S br

eake

ven

(%)

Buying Treasury Inflation Protected Securities (TIPS) is among our Top 10 ideas for 2017...

Source: Bloomberg

2.0

2.5

1.0

1.5

0.0

0.5

Nov

-12

Nov

-15

May

-15

Nov

-14

May

-14

Nov

-13

May

-13

May

-16

3.0

Fig. 38

…and we also like US loans, which offer both yield and protection against rising rates.

Source: Bloomberg

Fig. 39

USloans

5.9

0.8

–0.2

Euroloans

USinvest-mentgrade

Euroinvest-mentgrade

Swissfranchighgrade

3

4

2

–1

1

6

5

7

0

2.4

4.7

Cur

rent

yie

ld (%

)

Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16

3

1.8

2.2

2.6

1

1.4

3.4

Investment grade corporate bonds offer a small yield pickup

Source: Bloomberg

US investment grade (%) US high grade (%)

Yie

ld (%

)

Fig. 40

1986 1990 1994 1998 2002 2006 2010 2014

4

6

8

0

2

10

We are more cautious on long-maturity IGbonds, due to their interest rate sensitivity.

Source: Bloomberg

Yea

rs o

f yi

eld

wip

ed o

ut b

y a

1% m

ove

in y

ield

s (y

)

Fig. 41

102 ubs.com/cio

Yields on US high yield bonds have fallen by almost 4% since February. We expect performance to slow in the months ahead, and believe senior loans (page 61) are a better alternative.

EM sovereign credit spreads will trend sideways to slightly tighter in the next six months, and we advise investors to remain neutral in diversified portfolios.

Bonds

9

10

US

high

yie

ld,

yiel

d to

wor

st (%

)

6

8

7

4

5A

pr-1

6

Jan-

16

Oct

-15

Jul-1

5

Apr

-15

Jan-

15

Oct

-14

Jul-1

4

Apr

-14

Jan-

14

Jul-1

6

Oct

-16

11

We are neutral on US and euro high yield,aer exceptional performance in 2016…

Source: BAML, UBS

Fig. 42

450

500

EMBI

spr

ead

(bps

)

300

400

350

200

250

Nov

-15

May

-15

Nov

-14

May

-14

Nov

-13

May

-13

Nov

-12

May

-12

Nov

-11

May

-16

550

600

…and see only limited scope for a furtherrally in emerging market (EM) bonds

Source: JP Morgan, Bloomberg

Fig. 43


Equities and high grade bonds have enjoyed sustained periods of positive correlation three times in the past five years around turning points in monetary policy. These periods boost the attractiveness of less- correlated assets like hedge funds.

We currently recommend allocations of 16% – 20% to alternatives for most inves-tors; they provide both return and diversifi-cation with limited additional risk.

Alternative investments

Alternatives – hedge funds and private markets – are key ingredients in a well-diversi-fied portfolio. They provide investors with diversification, returns, and access to alter-native risk premiums.

13-w

eek

corr

elat

ion,

S&

P 50

0 vs

5–7y

USD

hig

h gr

ade

bond

s

–0.6

–0.2

–0.4

–1.0

–0.8

2015

2014

2013

2012

2011

2010

2009

2016

0.6

0.4

0.2

0.0

0.8

Equity-bond correlation can rise aroundturning points in monetary policy…

Source: Bloomberg

Fig. 44

…making less-correlated assets,like alternatives, more valuable.

Source: UBS

Equities/bonds

Alternatives

80–84%

16–20%

Fig. 45

104 ubs.com/cio

Hedge fund performance should be boosted by steady rises in US rates and equity markets, and by higher stock dispersion. Longer term, we expect hedge funds to provide a return-to-risk ratio superior to other assets.

Diversification remains the best approach to hedge fund investing. For instance, although systematic traders performed relatively poorly as a standalone invest-ment in 2016, they significantly improved overall portfolio return/risk.

Private markets, in our estimate, will offer returns of 8.5%–12%, higher than most equity markets, with volatility closer to that of high yield bonds.

The difference between the top and bot-tom quartile for private equity managers can be up to 20% – substantially larger than it is for funds of publicly traded stocks. Selecting the right manager is key.

Alternative investments

Our recommended portfolio is diversifiedacross a range of managers and styles.

Source: UBS

Relative value

Macro and trading

Equity hedge

Event driven

20%

42.5%

20%

17.5%

Fig. 47

1.0

0

0.5

US

equi

ties

Euro

zone

equ

ities

USD

hig

h gr

ade

bond

s 5–

7yrs

USD

hig

h yi

eld

bond

s

USD

inte

rmed

iate

corp

orat

e bo

nds

Priv

ate

real

est

ate

Priv

ate

debt

Priv

ate

equi

ty

Hed

ge f

unds

EM e

quiti

es

1.5

We expect hedge fund returns of 4–6%in 2017

Source: UBS

Fig. 46

10

0

5

121086420 14

25

20

15

30

EM equities

Eurozoneequities

Private equityPrivate real

estatePrivate

debt

US equities

USD high yield bonds

Hedge funds

USDcorporate bonds

USD highgrade bonds

5–7yrs

We expect private markets to offer superiorreturns relative to volatility than other assetsover the next 10 years…

Source: UBS

Fig. 48

Risk (%)

Return (%) USBuyout

European StockFunds

US StockFunds

EuropeanBuyout

10

15

20

0

5

25 In %

….but manager selection is key, given thewide performance difference between topand bottom-quartile managers.

Source: UBS, Hamilton Lane

25th percentile Median 75th percentile

Ten

Yea

r Ti

me

Wei

ghte

dRe

turn

s

Fig. 49


Although we are cautious in the near term, we expect demand (an additional 1.1mbpd) for crude to outstrip supply (an additional 0.5mbpd) in 2017.

Commodities

Commodities mounted a comeback in 2016 after a long decline. Palladium and platinum and are our top picks within commodities as we enter the year.

0.0

0.5

Surp

lus

/ (de

ficit)

(mbp

d)

–1.5

–0.5

–1.0

–2.5

–2.0

1Q20

17

3Q20

16

1Q20

16

3Q20

15

1Q20

15

3Q20

14

1Q20

14

3Q20

13

1Q20

13

3Q20

12

1Q20

12

3Q20

11

1Q20

11

3Q20

10

1Q20

10

3Q20

171.0

1.5

2.0

2.5

Surplus

Deficit

We expect oil prices to trade at at USD 60/bbl in 12months as demand outstrips supply.

Source: IEA, UBS

Fig. 51

Over the long term, commodities are likely to deliver positive but unattractive returns on a risk-adjusted basis. But tactical com-modity opportunities may emerge over a short-term time horizon.

Bloo

mbe

rg C

omm

oditi

es in

dex

Tota

l Ret

urn

(%)

100

200

150

0

50

2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

2016

250

Long-term commodity returns are unattrac-tive, but tactical opportunities can emerge.

Source: Bloomberg

Fig. 50

106 ubs.com/cio

Both white metals are expected to benefit from improving demand and contracting mine supply.

Commodities

8

10

Yea

r-on

-yea

r ch

ange

in c

ar s

ales

(3m

ma,

%)

2

6

4

–2

0

2015

2014

2013

2012

2011

2016

12

We expect rising car sales to support palladium and platinum; they are among our Top 10 Ideas for 2017.


Fig. 53

Federal Reserve interest rate hikes could weigh on gold prices in the near term. But as real rates fall more deeply into negative territory through the year (see page 36), we expect prices to rise toward USD 1,350/oz.

0

1

US

inte

rest

rat

es m

inus

CPI

infla

tion

(%)

–3

–1

–2

–5

–4

May

-15

Oct

-14

Mar

-14

Aug

-13

Jan-

13Ju

n-12

Nov

-11

Apr

-11

Sep-

10Fe

b-10

Jul-0

9D

ec-0

8M

ay-0

8O

ct-0

7M

ar-0

7

Feb-

17Ju

l-16

Dec

-15

Sep-

17

2

3

Gold should be supported by even moredeeply negative US real interest rates.


Fig. 52


Both currencies could derive support in the course of any market volatility, but we expect them to end the year weaker. We forecast EURUSD to trade at 1.20 in 12 months, and EURCHF to trade at 1.16.

We expect stronger performance from the euro, as the European Central Bank scales back its easing program. The British pound will be vulnerable during Brexit negotiations, but should trade stronger once greater clarity emerges.

Foreign exchangeSafe-haven currencies per-formed well in 2016. In the coming year, we expect stronger performance from the euro, British pound, and select emerging market (EM) currencies.

151050–5

GBP

EUR

USD

JPY

0%

Overvalued

CHF

–10–15 20–20

The safe-haven USD and CHF are over-valued versus other G10 currencies; and we expect them to depreciate.

Fig. 54

Source: UBS

Undervalued

17%

13%

–12%

–14%

Relative PPP

1.20

1.25

EURU

SD

1.10

1.15

1.00

1.05

Mar

-16

Nov

-15

Jul-1

5

Mar

-15

Nov

-14

Jul-1

4

Mar

-14

Nov

-13

Jul-1

3

Mar

-13

Nov

-12

Jul-1

61.30

12-monthforecast

1.20

1.35

1.40

1.45

ECB tapering QE will li the EUR, whileundervaluation should support the GBP.


Fig. 55

108 ubs.com/cio

Tactically, an emerging market (EM) for-eign exchange basket counts among our Top 10 ideas for 2017 (see page 45). We think accommodative monetary policy and low yields in developed market (DM) eco nomies makes the roughly 8% interest rate differential attractive.

In general, we advise hedging foreign exchange exposure, but currencies can provide investors with a tactical means of benefiting from economic developments like improvements in productivity or changes in monetary policy.

Foreign exchange

8

10

4

6

0

2

Sep-

16

Aug

-16

Jul-1

6

Jun-

16

May

-16

Apr

-16

Mar

-16

Feb-

16

Jan-

16

Dec

-15

Oct

-16

12

14

115

120

105

110

95

100

125

A basket of EM currencies versus selected DM currencies has attractive interest carry.

Source: Thomson Reuters, UBS

Relative yield (LHS, %)

EM/DM Basket return (indexed, RHS)

Fig. 56

Strategically we recommend hedging currency exposure.

Fig. 57

110 ubs.com/cio

Experts from around the Chief Investment Office were quizzed on potential surprises, risks, and opportuni-ties they’re looking out for in 2017. Here are some of their views...

1. What might surprise us in 2017?

Coherent US economic policy • Inflation • An economic accelera-tion in Japan • Food price inflation • Inflation makes a comeback • EM and Eurozone profit growth

Heard around CIO


3. What is the biggest potential opportu-nity in 2017?

Regulatory coordination • EM • Oil producer stocks • Renewing Europe • Brexit bringing reform to the Eurozone

2. What is the biggest risk to markets in 2017?

The gulf of understanding between markets and policymakers • A global growth slump • Expectations of markedly higher interest rates • An unexpected pickup in global inflation • Stagflation • China

112 ubs.com/cio

7. What is the best investment advice you’ve had?

Make a plan for the long run and stick to it in the short run • You should always feel uncomfortable with your investments • Remain humble • This time is never different • Diversify • To invest in my edu-cation and health • Choose invest-ments according to financial objectives

5. For the next 20?

Stocks • Impact or impactful investments • Global equities EM equities coupled with inflation-pro-tected securities • Diversified stocks based on long-term themes • Endowment style – private equity, infra structure and real estate

6. Which asset would you least like to own lots of?

Negative-yielding corporate bonds • Government bonds • US Treasuries • Swiss long-dated government bonds • A large, single-stock holding

4. Where would you invest your cash for the next year?

Private equity • In a diversified global portfolio with an overweight in stocks • A diversified portfolio of stocks, corporate bonds and alter-natives • Tax-exempt pension savings • Allocating systematically between stocks and bonds • Risk parity

Heard around CIO


Economics GDP growth (%) Inflation (%)

Region 2016 2017 2018 2016 2017 2018

US 1.5 2.4 2.5 1.3 2.3 2.3

Eurozone 1.6 1.3 1.2 0.2 1.4 1.8

China 6.7 6.4 6.0 1.9 2.1 1.8

Japan 0.5 0.8 0.9 -0.3 0.5 0.6

UK 2.0 1.0 0.7 0.7 2.8 2.8

Switzerland 1.5 1.3 1.6 -0.4 0.4 0.9

Advanced economies 1.6 1.8 1.9 0.7 1.8 1.9

Emerging market 4.4 4.9 5.1 4.2 3.8 3.5

World 3.1 3.5 3.6 2.6 2.9 2.8

Currencies Spot 3m 6m 12m

EURUSD 1.08 1.12 1.15 1.20

USDJPY 108 102 102 98

GBPUSD 1.26 1.25 1.28 1.36

USDCHF 0.99 0.96 0.97 0.97

EURCHF 1.07 1.08 1.12 1.16

EURGBP 0.86 0.90 0.90 0.88

USDCNY 6.81 6.85 7.00 7.00

Commodities Spot 6m 12m

Brent crude oil USD 44.8/bbl USD 55/bbl USD 60/bbl

WTI crude oil USD 43.4/bbl USD 53/bbl USD 58/bbl

Gold USD 1,225/oz USD 1,350/oz USD 1,350/oz

Platinum USD 949/oz USD 1,150/oz USD 1,150/oz

Palladium USD 680/olz USD 750/oz USD 750/oz

Rates and bonds Base rates 10–year yields (%)

Current end–2016 end–2017 Spot 6m 12m

US 0.25-0.5 0.5-0.75 1.00-1.25 2.23 2.20 2.30

Euro 0.00 0.00 0.00 0.36 0.30 0.40

Switzerland -0.75 -0.75 -0.75 -0.17 -0.20 -0.10

UK 0.25 0.25 0.10 1.36 1.30 1.40

Source: UBS, as of November 14, 2016

Forecasts

UBS House View: Year Ahead 2017This report has been prepared by UBS AG, UBS Switzerland AG and UBS Financial Services Inc. (”UBS FS”).

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