UBS Investment Strategy Guide

a

b

UBS Wealth Management Research / 24 April 2007

UBS Investment Strategy Guide

Re-adjusting our equity exposure

Over the past weeks, we have seen a strong recovery in global
equity markets, validating our decision to raise equity exposure
in early March. Now, as prices have climbed even somewhat
above pre-correction levels in most markets, we have adjusted
our equity exposure downwards. We maintain a moderate
overweight, but given reduced return expectations as prices
have increased, we think that a less aggressive positioning is
warranted now.

Core Asset Allocation
During the sell-off in late February and early March, we decided to
upgrade our equity exposure, as improved valuations had signaled a
more favorable return outlook. We judged that the problems in the US
subprime markets and related risks to US growth and earnings did not
justify such a strong correction. With hindsight, the decision to
upgrade equities proved beneficial as markets have rallied strongly
since then. Most markets have even topped their previous highs, with
global equities up about 7% from their lows, and some European
markets even up more than 10%. Markets in Asia and Latin America
also posted strong gains. Looking ahead, these gains have eaten away
some of the extra upward potential in equities we identified in early
March. We have therefore decided to reduce our equity exposure, but
retain a moderate overweight in our asset allocation.

Strategy Changes
Besides the reduction in our equity overweight, we have made some
changes to our equity market strategy. We reduced our overweight in
emerging markets and the Eurozone, and downgraded Singapore to
neutral. These changes were balanced by reduced underweights in
Canada and Japan. In fixed income, we adjusted our overall duration
allocation upwards,
for shorter
maturities. However, we keep an overall moderate below benchmark
duration, which is mainly concentrated in the JPY, CHF, EUR, and SEK
markets. For USD bonds we have increased duration to neutral.

Walter Edelmann, Strategist

reducing our preference

thus

Contents
Focus: Australia and Global Investment Trends
Economic Outlook
Extended Asset Allocation
Currency Strategy
Equity Market Strategy
Equity Sector Strategy
Fixed Income Strategy
Credit Strategy
Commodity Strategy

Page
2
5
6
7
8
10
11
12
13

Global Asset Class Returns1
in %
Money Market
Government Bonds
Corporate Bonds
Equities3

2006
3.0
0.9
3.5
15.5

YTD
1.2
0.4
0.7
6.0

next 12 m2
4.1
3.5
3.2
7.5

1Total returns in local currency, weighted averages of main markets.
2Expected return in the next 12 months. 3MSCI.
Sources: Thomson Financial, Bloomberg, UBS WMR, as of 24 April
2007

Core Market Views – hedged1

US
Canada
EMU
UK
Switzerland
Sweden
Japan
Australia
Hong Kong
Singapore
Em. Markets

Global Equities
Global Bonds

Bond Port-
folio
+
–
–
+
–
–
–
+
n.a.
n.a.
n.a.

Currency
Overlay
–
–
+
n
+
n
+
–
n.a.
n.a.
n.a.

Equity Port-
folio
+
–
+
+
n
n
– –
–
n
n
+
Cross asset class
+
–

Labels: + = moderate overweight, ++ = overweight, +++ = strong
overweight, n = neutral, – = moderate underweight, — = under-
weight, — = strong underweight, n.a. = not applicable.
Source: UBS WMR, as of 24 April 2007

1Note: The table indicates the relative attractiveness of coun-
tries/regions within internationally diversified pure bond and pure
equity portfolios respectively. The currency exposure of foreign in-
vestments is assumed to be fully hedged (which implies that changes
in currencies do not impact performance). Currency considerations
are treated separately (see third column).

This report has been prepared by UBS Financial Services Inc. (“UBSFS”) and UBS AG
Please see important disclaimer and disclosures at the end of the document.

UBS Wealth Management Research / 24 April 2007

Focus: Australia and Global Investment
Trends

investment trends have

Real Estate Boom, Commodity Boom, Asian Growth: Many of

the current global
impacted the
Australian economy more than other countries. In this Focus
article we take a closer look how these global themes have
worked in the past, and what impact these trends may have in
the rest of 2007 – both for Australia and the global markets.

Big performance in a small market
The Australian stock market may be overlooked by many international
investors. For example, when Europeans think of Australia, it is often as
a great place for a vacation, but not necessarily a great place to invest.
However, over the last ten years, the Australian stock market has out-
performed the global stock market by more than 5% per year (Fig. 1).
At the same time, the volatility of Australian stocks was slightly lower
than the volatility of the global market. Even during the latest equity
market correction in early March, Australian stocks continued to out-
perform global stock markets.

Australian stocks helped by real estate and commodity boom
One of the reasons for Australia’s strong performance in the past can
be seen in Fig. 2. The Australian stock market is overly exposed to the
sectors which performed well globally in recent years, and underex-
posed to those sectors where performance was weak. The commodity
boom of the last several years led to very strong performance in the
materials sector, and the ongoing boom in listed real estate markets
globally also lifted Australian listed real estate companies. These com-
panies make up a significant part of the Financials sector, also shown in
Fig. 2, accounting for 11% of the equity market’s total capitalization.
In a sense, the Australian stock market itself can be seen as a diversi-
fied portfolio of underlying exposures to real estate, commodities as
well as the more traditional sectors.

Commodity stocks and commodity prices
To be sure, there are important differences between commodity stocks
(companies) and direct investments in commodities like copper, zinc,
etc. Fig. 3 compares the performance of Australian materials compa-
nies ₋ mostly mining companies ₋ with the global mining industry and
with a direct investment in gold or copper over the last ten years. It is
obvious that while commodity stocks follow the long-term commodity
boom, in the short run the performance of commodity companies can
be vastly different from direct investments in commodities. This is be-
cause share prices of materials companies not only depend on current
commodity prices, but finally on their expected earnings streams. Earn-
ings are generated from the sale of commodities but at the expense of
production costs, and may depend for example on softer issues like the
quality of management. These factors tend to dilute the link between
commodity prices and commodity stock performance.

Commodities outlook
We expect commodity prices generally to remain elevated in 2007. We
think metals’ prices should continue to rise as inventories at the Lon-
don Metal Exchange (LME) remain at critically low levels and we think
supplies are likely to remain constrained. Demand for copper and other
metals has remained firm, especially due to increased buying by China.
While, at the beginning of the year, the prospects of a US economic

Fig. 1: Australian Stock Market Outperformed
Performance of MSCI Australia vs. MSCI World

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MSCI Australia

MSCI World

Sources: MSCI, UBS WMR, as of 13 April 2007

Fig. 2: Australian vs Global Sector Composition
Australian market with large exposure to listed real estate
and materials companies

World

Australia

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Sources: MSCI, UBS WMR, as of 13 April 2007

Fig. 3: Commodity Stocks vs Commodity Returns
Commodity stocks do not always mirror commodity prices

Copper TR

Gold TR

Australia Materials

World Metals and Mining

04/97

04/99

04/01

04/03

04/05

04/07

Sources: Dow Jones AIG, MSCI, UBS WMR, as of 13 April 2007

Investment Strategy Guide 2

slowdown eroded the market’s confidence in the demand prospects
for base metals, the fundamental conditions for base metals have re-
mained firm.

Regarding energy commodities, we note that relatively high US crude
oil inventories are due to imports and not a lack of supply. OECD in-
ventories are at their lowest levels in the last 10 years. Finally, we think
that weather related factors, such as the hurricane season, could add a
premium to energy prices, irrespective of whether a heavy storm sea-
son materializes or not. We expect no change in the price premium
stemming from potential geopolitical tensions in the Middle East.

Listed real estate stocks boom
Listed real estate companies have experienced strong investment in-
flows lately from institutional and private investors around the world,
who wanted to diversify into this asset class. As a result, global real es-
tate has become pricey, and investor sentiment about growth pros-
pects seems to be playing a role, especially during the past two years.
Investors seem more optimistic, as seen by the widening blue area in
Fig. 4, which shows the increasing value ascribed to future growth as
part of the total investment in Australian listed real estate.

However, many listed real estate companies learned their lessons from
previous boom and bust cycles. In the 1980s Australia experienced a
real estate boom as interest rates declined, making it more attractive to
develop new property. Other factors such as market deregulation also
added to this boom. As a result, more developments were made than
were actually needed in the market. This oversupply, together with
gradually rising interest rates and other local factors, led to declining
real estate markets and a burst of the Australian real estate bubble in
the 1990s.

What is different in this real estate boom
Today, global listed real estate companies face a similar boom-like
situation in that low global interest rates are spurring construction ac-
tivities and more aggressive financing. However, we think that con-
struction activity is not excessively speculative in most regions. Indeed,
we think that additional office space in Australia, and globally, will
meet growing demand from financial institutions and other service
businesses around the world. Furthermore, listed real estate companies
increasingly are changing their business model to become less depend-
ent on traditional sources of income such as rents, thus increasing their
future growth opportunities (Fig. 5). New sources of income changes
company risk profiles, making them less sensitive to declining rental
income. Hence we think that, despite elevated valuations, listed real
estate companies may still be an interesting asset class throughout the
rest of 2007.

Economic strength drives the Australian stock market
Another important reason for the resilience of the Australian stock
market has been extraordinary macroeconomic stability. In 2007 Aus-
tralia will be heading into its sixteenth year of economic expansion.
While other industrialized countries have experienced one or two re-
cessions in the same period, Australia kept on growing at a positive
rate. In a global rating of economic resilience, Australia has ranked at
the top spot for several years now (Fig. 6).

This stability has partly been a result of the strong growth in Asia and
the shift it has brought about in Australia’s in exports throughout the
last decade. Australia’s main exports are commodities from the coun-

UBS Wealth Management Research / 24 April 2007

Fig. 4: Australian Listed Real Estate
A lot of future growth opportunities are already priced in

present
value
of future
growth

price
without
growth

160

140

120

100

80

60

40

20

0

g
n
i
t
a
R

e
c
n
e

i
l
i
s
e
R

9

8

7

6

5

4

3

2

1

0

Apr.97 Apr.99 Apr.01 Apr.03 Apr.05 Apr.07

Sources: Thomson Financial, UBS WMR, as of 13 April 2007

Fig. 5: Real Estate Business Models
Four different business models and the impact of economic
drivers on these business models

Investor
Investor

Funds under
Funds under
Management Developer Trader
Management Developer Trader

GDP growth, job market
GDP growth, job market
Interest rates
Interest rates

Inflation
Inflation

Construction costs
Construction costs
Real estate fundaments (rents, etc.)
Real estate fundaments (rents, etc.)
Investment property supply/demand
Investment property supply/demand

Major impact
Major impact
Average impact
Average impact
Minimal impact
Minimal impact

Source: UBS WMR, as of 13 April 2007

Fig. 6: Resilience of Economy to Economic Cycles
Australia ranked best of 51 countries

7.6

6.7 6.4

6.1

5.5 5.5 5.3 5.2

4.5

3.9

3.5

K
U

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A

A
S
U

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Sources: IMD World Competitiveness Yearbook 2005, UBS WMR, as
of 13 April 2007

Investment Strategy Guide 3

UBS Wealth Management Research / 24 April 2007

Fig. 7: Exports to Asia Dominate
Exports as a % of total exports over time

USA

UK

New
Zealand

Japan Asia ex
Japan

90/91

94/95

99/00

04/05

Sources: ABS, DFAT, UBS WMR, as of 13 April 2007

Fig. 8: Equity Market Valuation
Australian stocks relatively expensive

30

25

20

15

10

5

0

s
t
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p
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e

l

a
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%

s
a

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x
E

UK
EMU
US
World
Japan

Australia
Switzerland
Canada
Norway

e
v

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p
x
E

-30% -20% -10% 0% 10%

Price/Value Discrepancy

Source: UBS WMR, as of 13 April 2007

p
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try’s mines, which make up about one third of total exports. The rap-
idly growing economies of Asia, rather than Japan or the US, have
been consuming more of Australia’s exports over the last decade (Fig.
7). We think this trend is likely to continue in the future as well.

Valuations stretched for Australian equities
Of course, everything has its price and economic success has already
had an impact, stretching the valuations of Australian stocks. Our divi-
dend discount model shows that Australian stocks are among the most
expensive globally, together with Canada and Norway, both markets
that have profited strongly from high energy prices. This expensive
valuation leads us to underweight Australia and Canada in our global
equity market strategy.

Future Fund as additional demand factor
However, any eventual underperformance in Australia may be miti-
gated by new demand for Australian equities from the future fund. In
response to the under-funded governmental superannuation liabilities
and evolving demographic changes, the Australian government estab-
lished the Future Fund with the purpose of offsetting governmental
liabilities by 2020. Except for an AUD 9bn stake in the country’s largest
telecommunication company, the fund currently holds AUD 41bn AUD
in cash and should start investing as soon as next month. Depending
on the asset allocation of the fund, this might result in additional AUD
14bn flowing into the market, which is approximately 1% of total
market capitalization.

Conclusions
Listed real estate investments and commodities are likely to continue to
do well in 2007, albeit growing at a somewhat slower pace than in the
last few years. We also note that due to more demanding price levels,
risks for temporary setbacks have increased. As a special case, Australia
is likely to profit indirectly from the ongoing commodity boom and the
growth in Asia as well as in the real estate sector. Yet one should be
careful not to confuse a good economy with a good (equity) invest-
ment.

We are convinced that current expensive valuations for Australian equi-
ties, as well as other, commodity-driven countries like Canada, will be
brought back in line with global levels over time. Special demand fac-
tors in Australia like fund-buying may counteract these effects in the
short-run but we do not think they are likely to dominate in the longer
term.

Overall, we recommend that investors interested in investing in com-
modities to pursue direct investments rather than indirect structures via
equity market exposure. Given continued growth in the global econ-
omy, we think real estate and commodities remain opportunities which
should be explored in the context of a well-diversified portfolio.

Joachim Klement, Strategist
Ioannis Drikos, Strategist

Investment Strategy Guide 4

Economic Outlook: Asia is strong

While the US should record a rather tame first-quarter growth

rate in 2007 and Europe is doing fine, China continues to boom.
We have also revised our Japanese growth rate upward.

Growth: We have not changed our growth forecasts for the US and
Europe. As we predicted, the US continues to show signs of weakening
and we should see a growth rate below 2% in Q1 2007, which will be
the fourth quarter in a row with sub-trend growth. The Eurozone data
are more or less in line with our current solid 2.5% growth forecasts
for 2007. We had to revise Japan slightly upward due to better–than-
expected activity indicators in the first three months of the year. Now
we expect Japan to have the same 2% growth rate as the US. It may
well be that, for the first time since 2001, both the Eurozone and Ja-
pan post higher growth than the US in 2007. The single outperformer
in terms of growth, however, remains China, which grew by 11.1% in
Q1 2007. This astonishing result has led us to revise the Chinese
growth upward to 10.4% in 2007 and 10.6% in 2008.

Inflation: We are far less concerned about inflation than most market
participants, especially with regards to the US. While currently we still
see above-average inflation there, even in the core rate, the base ef-
fects that may materialize in the coming months should restrain this
rate to 2%. In Europe, inflation seems well under control. The only
area of major concern we currently have is China, where inflation ac-
celerated from 2.2% in January to 3.3% in March. This led us to revise
our inflation outlook upward for the whole of 2007, and we now ex-
pect 3.1% on average.

Short-term Interest Rates: We expect far more rate cuts from the
Fed than the current market consensus. Fed fund rates could go as low
as 3.75% by the end of 2008, in our view. The trigger for this will be
an increase in the unemployment rate, which always lags a little bit be-
hind the rest of the business cycle, but we believe this will occur in the
next couple of months. We forecast more rate-hiking by the European
Central Bank than the markets generally expect: two hikes as opposed
one in the next twelve months.

Bond Yields: In our view bond yields should continue evolving in tight
ranges over the next twelve months. Both retreating or stabilizing infla-
tion rates as well as slowing growth rates support this scenario. A more
restrictive Chinese monetary policy represents another risk factor, we
note, given the accelerating inflation there. This could lead to some
selling of international bonds held by China as part of its foreign re-
serves or at least a reduced demand for them.

Andreas Hoefert, Economist

UBS Wealth Management Research / 24 April 2007

GDP Growth

’07 F2 ’08 F2

Growth and Inflation Forecasts
in %

World
US
Canada
Japan
Euro-Zone
Germany
France

Italy
Spain
UK
Switzerland
China
Asia / Pacific1

’06
’06
3.6
5.2
3.2
3.3
2.1
2.9
0.2
2.1
2.2
2.7
1.7
2.7
1.7
2.0
2.1
2.0
3.5
3.8
2.3
2.7
2.8
1.1
10.7 10.4 10.6 1.4
6.0
9.0

4.8
2.0
2.7
1.8
2.2
2.0
1.8
1.4
2.7
2.2
2.0

4.6
2.0
2.5
2.0
2.5
2.6
2.0
1.9
3.3
2.5
1.8

7.8

7.8

Inflation

’07 F2 ’08 F2

3.4
2.1
1.8
0.1
1.9
2.0
1.5
1.9
2.8
2.1
0.4
3.1
5.5

3.4
2.4
1.8
0.5
1.8
1.5
1.7
2.1
2.6
1.8
0.8
3.3
4.0

1Excluding Japan. 2E: estimate, F: forecast.
Source: UBS WMR, as of 24 April 2007

Main Economic Forecasts
Deviations from consensus in %-points; for 2007

USA

Canada

Japan

Germany

France

Italy

Spain

Euro-Zone

UK

Switzerland

Inflation (CPI)

GDP growth

-0.75 -0.50 -0.25 0.00

0.25

0.50

0.75

Sources: Consensus Economics, UBS WMR, as of 24 April 2007

Interest Rate and Exchange Rate Forecasts
in %

US
Canada
Japan
Euro-Zone
UK
Switzerland

USD rate1
in

Short rates
(3m) in

Bond yields
(10y) in
6 m 12 m 6 m 12 m 6 m 12 m
4.70 4.00 4.50 4.70 1.00 1.00
4.20 4.30 4.20 4.20 1.16 1.18
0.90 1.10 1.80 1.90 114 110
4.50 4.50 4.20 4.30 1.36 1.30
5.70 5.50 4.80 4.70 0.52 0.53
2.50 2.50 2.70 2.80 1.18 1.20

1USD exchange rate.
Source: UBS WMR, as of 24 April 2007

Investment Strategy Guide 5