Wealth Management Research

26 June 2012

Global risk watch

No US fiscal cliff, but beware the pothole
US policymakers face a significant challenge. If they fail to take legislative action, a series of fiscal measures will expire as of 1 Jan. 2013. If allowed to happen without rapid corrective measures, this would very likely lead to a US recession in early 2013 and spell trouble for most financial assets. We believe that this adverse "fiscal cliff" scenario is very unlikely to materialize. However, it appears more likely that a much milder version thereof could take place and cause slower growth early next year. A "fiscal pothole" scenario could emerge if relevant fiscal provisions are allowed to temporarily expire (with a later retroactive fix) or if a limited number of provisions are allowed to expire permanently. While we do not yet see clear signs that the threat of the fiscal cliff is already having a material impact on hiring and spending decisions, this does pose a potential risk to our outlook for the balance of 2012. Going beyond the early-2013 risk of a fiscal cliff, we argue that whether a Grand Bargain that implements a sustainable fiscal austerity program is reached during the first half of the year or not will have a material impact on the economic and financial market outlook. As the US presidential election campaign heats up, investors are increasingly focusing on key risks to the economic outlook, that may arise in the election aftermath, in particular the risk that fiscal policy could be abruptly tightened in early 2013. This risk arises because according to currently enacted law, various fiscal provisions will automatically enter into force in January 2013 unless Congress takes some legislative action. All these measures would have the effect of simultaneously tightening fiscal policy. And while most economists agree on the need for fiscal austerity to place US public finances on a more sustainable path, it is also recognized that the impending "fiscal cliff" would be so concentrated in time and of such a magnitude that it would most likely plunge the US into a renewed recession.
Stephen Freedman, CFA, strategist, UBS FS stephen.freedman@ubs.com, +1 212 713 8666 Thomas Berner, CFA, economist, UBS FS thomas.berner@ubs.com, +1 212 713 4108 David Lefkowitz, CFA, strategist, UBS FS david.lefkowitz@ubs.com, +1 212 713 3739

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 17.

Global risk watch

What is at stake?
Fiscal austerity a threat to the US economy The key fiscal measures that are scheduled to take effect in January 2013 include the following (Fig. 1 shows all the measures): - The Bush-era tax cuts sunset - Automatic spending cuts (or sequestration) mandated by the Budget Control Act (BCA) kick in, resulting in defense and healthcare spending reductions. - Payroll tax holiday expires - Emergency unemployment benefits expire According to a May 2012 report by the nonpartisan Congressional Budget Office (CBO), the fiscal contraction of these combined measures amounts to $607 billion between fiscal years 2012 and 2013 (see Fig. 1). After this fiscal cliff and once these measures have made their way through the economic system, they would act as a negative drag on the US economy and almost surely cause a recession. If rationality prevails a big if DC policymakers would reach an agreement to avoid such a negative economic outcome. However, several factors suggest that it remains a relevant risk case worth analyzing in a Global Risk Watch report: - Any attempt to prevent a fiscal cliff and economic shock later this year must also be paired with a credible strategy to combat government budget deficits over the next decade. - Extreme levels of polarization within Congress, diverging views about the appropriate mix of spending cuts and revenue increases needed to achieve fiscal sustainability and a poor track record of bipartisan problem solving on Capitol Hill raise the risk that negotiations could hit a dead end, even with full knowledge of the economic consequences of a stalemate. - We expect a breach of the recently increased debt ceiling in late 2012, with the US Treasury Department postponing the day of reckoning into early 2013 with the use of extraordinary measures. Therefore, just as during the summer of 2011, talks regarding an increase in the debt ceiling are likely to be taken hostage by negotiations about deficit reduction measures. The threat of a technical default raises the stakes for other negotiations. While a looming default may produce a breakthrough, it also creates the risk of a breakdown.

Fig. 2: Uncertainty undermines confidence Policy uncertainty index and ISM manufacturing index
65 60 55 50 45 40 35 30 300 250 200 150 100 50 0

1985 1990 1995 2000 2005 2010 ISM Manufacturing Index (left scale) Policy Uncertainty Index (right scale)

Source: www.policyuncertainty.com, Bloomberg, UBS as of May 2012 Note: The Economic Policy Uncertainty Index (see "Measuring Economic Policy Uncertainty", (2012), Scott R. Baker, Nicholas Bloom and Steve Davis, Stanford mimeo) captures three types of underlying components. One component quantifies newspaper coverage of policyrelated economic uncertainty. A second component reflects the number of federal tax code provisions set to expire in future years. The third component uses disagreement among economic forecasters as a proxy for uncertainty.

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Policy uncertainty hurts business confidence While the fiscal cliff is primarily a risk for early 2013, the mere policy uncertainty surrounding this issue could create a drag on growth later this year. As Fig. 2 suggests, economic policy uncertainty can have a direct adverse effect on business confidence. Our baseline economic scenario does not reflect such an outcome. Therefore, evidence that policy uncertainty is undermining confidence would create downside risks to our central case. A June survey by the National Federation of Independent Businesses indicates some cause for concern, concluding that: The amount of political manipulation and evasion to guide the spending of billions of taxpayer dollars is disturbing to owners. Sixty (60) percent of those surveyed said now is a bad time to expand their businesses; one-in four of those owners cited political uncertainty as the main reason, second only to concerns about a weak economy. Investing in jobs or plant and equipment will remain at maintenance level until this is resolved. To obtain another point of reference on fiscal cliff-related uncertainty, we polled WMRs US sector analysts, asking them whether they saw signs that companies were holding back from making investments, altering their corporate strategy, changing their capital management preferences (i.e. using excess cash for share buybacks versus increasing dividends at the margin), and whether they saw any other hot button issues. The results in Fig. 3 indicate some degree of caution regarding investments within some sectors, while expense control was a constant theme running through a majority of sectors. More apparent signs of caution can be distinguished on the corporate finance side (rather than on spending decisions). Most companies currently prefer the flexibility of using buybacks rather than raising dividends and incurring additional fixed dividend payments amid high uncertainty. Overall, we do not view these results as conclusive evidence that policy uncertainty is likely to have a significant economic impact during the second half of the year. However, they do indicate that some downside risk exists and that such surveys will need to be evaluated over time.

Fig. 3: Preparing for the impact of a fiscal cliff? Survey of WMR US sector analysts

Source: UBS, as of 21 June 2012

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Scenario analysis
No action before the election: In order to address the possible range of outcomes to the fiscal cliff, we start with the assumption that nothing will get done prior to the November elections. We think this is a fair assumption given the historical difficulty of passing major legislation in an election year. Unless the US economy goes into a tailspin, it is highly unlikely that the two parties would work to forge a compromise on major issues at a time when they are trying to rally supporters for the upcoming election. Election result shapes the path forward: With the election still five months away, Mitt Romneys running mate is not yet known, and most voters will likely not pay close attention to the campaign until after the conventions in the late summer. Therefore, any prediction about the outcome of the election has to be taken with a grain of salt. That being said, we can lay out the likely outcomes based on what we know now and make any changes to these outcomes and/or the probabilities we attach to them as the campaign evolves. At this point we see two main political scenarios, whereby we assign a slightly probability to the first: 1) Status quo: President Obama is reelected, Republicans lose some seats in the House of Representatives but retain a majority and Democrats lose some seats in the Senate but control is a tossup. 2) Republican control: Mitt Romney wins the White House, Republicans retain a similar majority in the House as exists today and Republicans gain a slim majority in the Senate. The election results will shape how Washington handles the fiscal cliff. However, regardless of who wins in November, decisions will likely be taken in two stages, first in the lame duck session of Congress and then when the administration and Congress are seated in 2013. Lame duck: Outcomes in this phase are similar under both election scenarios, although the probabilities differ (Fig. 5): - No extension: None of the expiring tax provisions are extended and the automatic sequester spending cuts kick in as scheduled on the first business day of 2013. - Partial extension into first quarter 2013: Some tax provisions are extended, but others expire as scheduled. Both Republicans and Democrats have indicated they support allowing the employee payroll tax cut and the emergency unemployment benefits to expire. Additionally, the sequestration spending cuts are delayed by a few months. - Full extension into first quarter 2013: Republicans and Democrats agree to disagree and extend all

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provisions into the first quarter. Sequester spending cuts are also postponed by a few months. - We think a small deal on all the provisions including sequestration spanning 1-2 years is nearly impossible during the lame duck session. Conceptually, we label scenarios that involve no extension or partial extension of expiring fiscal provision as a fiscal pothole. In the no extension case, this can evolve into a fiscal cliff if no retroactive corrective measures are passed in early 2013. Early 2013: After the administration takes the reins in midJanuary a few outcomes are possible. We think these outcomes will be similar, but not exactly equal in the two main election scenarios: - No deal: No deal can be reached in the first quarter. Since negotiations are likely to be linked to the issue of whether or not to extend the debt ceiling, a failure to reach a deficit reduction deal could spell significant trouble and even be associated with a technical default by the US Treasury. We consider that under the Republican control scenario, the likelihood of this scenario is nearly insignificant. - Kicking the can: A small budget deal is reached. Small means that it incorporates less than USD 2tn in deficit cuts over a 10-year period. Standard & Poors announced in its US sovereign rating outlook that the US government would have to cut its deficits by more than USD 4tn in order to have a stable rating outlook. Under the BCA of 2011, a total of USD 917bn deficit cuts over 10 years were agreed upon and the failure of the Supercommittee to agree on more cuts will under current law trigger an additional USD 1.2tn in cuts starting in 2013 for 10 years. Therefore additional cuts of at least USD 2tn are needed to avoid further rating downgrades. Therefore, we see a high likelihood of a rating downgrade in this scenario. - Grand Bargain: A large deal encompassing deficit cuts of more than USD 2tn over ten years is reached. This avoids further rating downgrades as long as politicians dont backtrack on it later on. Main outcome scenarios for impact analysis Based on the decision tree analysis in Fig. 5, we distinguish five economic outcomes. The Congressional Budget Office (CBO) estimates the growth impact of some of these scenarios, although its scenarios and real GDP growth assumptions might not perfectly match ours. Fig. 4 shows the CBOs estimate of the economic impact.

Fig. 4: Congressional Budget Office growth estimates under different fiscal scenarios US real GDP growth projections, in %
2013 H1 2013 H2 2013 whole annualized annualized year Current law (fiscal cliff) -1.3 2.3 0.5 Extension of most expiring provisions (1) 1.7 2.5 2.1

(1) Provisions not extended include the payroll tax holiday and emergency unemployment benefit Source: CBO, May 2012

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Fig. 5: Outcomes and probabilities

Source: UBS

Additionally, we exemplify the possible growth impact in the five scenarios using the US news index 1 . We construct a model that estimates the US real GDP growth impact of an increase in policy uncertainty as measured by the US news index. A one standard deviation increase curtails US real GDP growth by 0.5% after two quarters (see Fig. 6). About five quarters later it recovers to its prior growth rate. As a comparison, during last years US debt ceiling debacle, the US news index rose by about 2.6 standard deviations. Over the same time period US real GDP growth decelerated sharply, but the US economy did not slide into recession. Fiscal policy uncertainty could be an important driver of economic activity during the lame duck session and into the first quarter of 2013.

Fig. 6: Impact of US news index on US real GDP growth US real GDP year-over-year growth, in %
1.5 1 0.5 0 -0.5 -1 -1.5 0 4 8 12 Real GDP year-over-year growth

# of quarters
16

95% confidence band

Source: www.policyuncertainty, Bloomberg, UBS, as of 21 June 2012

The US news index is part of the policy uncertainty index that is compiled by Scott R. Baker, Nick Bloom and Steven J. Davis. It measures the number of news articles that include words such as economic, uncertainty, taxes and similar. It can be downloaded at www.policyuncertainty.com

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1. Fiscal cliff: <5% A majority of relevant fiscal measures expire in early 2013 with no retroactive change during the first quarter. The US economy experiences a recession in the first half of the year. The risk of a technical default is high in this scenario. This is similar to the CBO scenario in Fig. 4 called Current law (fiscal cliff) and includes USD 607bn in deficit reduction. In this scenario the CBO estimates that US real GDP growth would contract by annualized 1.3% in the first half of 2013 and recover at a pace of annualized 2.3% in the second half. The full-year 2013 growth rate would be diminished to 0.5%. The full negative fiscal impact on the US economy would amount to 5.1% of GDP between calendar year 2012 and 2013. Once we incorporate economic feedback loops, which take into account lower tax income and higher spending on unemployment benefits due to the weaker economy, the net impact amounts to 4.7% of GDP. Given the high policy uncertainty pertaining to letting all tax provisions expire at the end of the year, we think that the US news index would initially rise and after it becomes clear that no deal is struck it would probably soar. A three standard deviation increase would be consistent with a US recession. 2. Fiscal pothole and kicking the can: 50% This is the most likely scenario in our view. A number of fiscal measures are allowed to expire in January 2013, namely to the employee payroll tax holiday and the emergency unemployment benefits. Together they account for USD 121bn, or about 0.7% of our estimate of 2013 nominal GDP. While most are extended retroactively during the first quarter, the policy uncertainty creates a growth slowdown, though not a recession. A small fiscal deal ensues amounting to kicking the can down the road. This would have a high associated chance of a downgrade and involve further need for fiscal consolidation at a later stage. This is akin to the CBOs scenario called Extension of most expiring provisions in Fig. 4. In this scenario policy uncertainty would still increase but not by as much as in our Fiscal cliff scenario. The increase would probably be around 1-2 standard deviations. 3. Fiscal pothole and Grand Bargain: 25% Like scenario number 2 except that a large fiscal deal is reached during the first quarter. A downgrade is averted and longer term fiscal sustainability can be achieved provided that policy makers stick to the agreed fiscal targets. In this scenario policy uncertainty would probably initially rise by as much as in our Fiscal pothole scenario, as they both start from the same premise. However, once it becomes clear that a large deal is within reach policy uncertainty would fall rapidly, which in turn would be growth supportive.

Fig. 7: US news index deteriorated in response to the increase in the eurozone news index US and eurozone news index
350 300 250 200 150 100 50 0 May-00 May-02 May-04 May-06 May-08 May-10 May-12 US news index Eurozone news index

Source: : www.policyuncertainty, Bloomberg, UBS, as of 21 June 2012

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Global risk watch

4. Kicking the can (without pothole): 15% While a cliff and pothole are both avoided, the small deal adopted by Congress means that downgrade risk remains high. Moreover, there is a further need for fiscal consolidation down the road. Policy uncertainty initially rises but then stays elevated or even rises further, as a small deal leaves the door open for further fiscal changes in the future, which would keep policy uncertainty elevated. 5. Grand Bargain (without pothole): <10% A short-term extension of expiring fiscal provisions prevents any abrupt fiscal tightening at the beginning of 2013. A large fiscal deal in early 2013 averts a downgrade and longer term fiscal sustainability can be achieved provided that policy makers stick to the agreed fiscal targets. In this scenario policy uncertainty would probably only rise marginally, by less than one standard deviation, because the expiring fiscal provisions get extended. Once it becomes clear that a large deal is achievable the US news index normalizes. Most likely outcome: a small deal in early 2013 Given our subjective probabilities along the branches of the decision tree in Fig. 5, we calculate the most likely outcome out of the five possible economic outcomes under each of the two main political scenarios: Status quo and Republican control. We reach the conclusion that in both cases a small deal (kicking the can) is the most likely outcome in the first quarter of 2013. In Fig. 8 we show how such a small deal could look like under the two main scenarios. The key differences between a small deal under the main scenario Status quo and the main scenario Republican control are: The personal income tax rate for high income earners in the Status quo scenario would likely be higher than today and than in the Republican control scenario. Obama is running on the platform to raise taxes for the rich. Middle and low income tax rates would probably stay the same in the Status quo scenario, but fall in the Republican control scenario. The same holds true for capital gains and dividend income taxes. Under the Status quo scenario they would probably rise higher than today and than in the Republican control scenario. However, even in the Republican control scenario we would expect somewhat higher capital gains and dividend income taxes. We also foresee that in the Status quo scenario the estate and gift tax rate will be higher, while the exemption limit will be lower than today and than in the Republican control scenario.

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Global risk watch

Obamas Affordable Care Act surtax on investment income (for income of less than USD 250,000) will likely come to bear under the Status quo scenario, while there is a good chance that it will be repealed or lowered under the Republican control scenario. In the Status quo scenario we think that Obama will push for taxation of pass-through entities, whereas in the Republican control scenario we expect a continuation of the current no taxation policy When it comes to overseas corporate profit taxes, we expect an end of taxation in the Republican control scenario coupled with a one-time chance of profit repatriation at a lower tax rate of 5.25%. Under the Status quo scenario we think the taxation as is today will be upheld. In both scenarios, however, we foresee an effort to close the legal loopholes to prevent tax avoidance. On the spending side, we expect discretionary defense spending in the Status quo scenario to fall more rapidly relative to the current rate in % of GDP as well as relative to the Republican control scenario. In contrast, discretionary non-defense spending will likely fall less quickly in the former scenario than in the latter. Mandatory Medicare spending will likely rise more quickly in the Status quo scenario than in the Republican control scenario, and Medicaid spending will likely remain roughly unchanged in the former scenario, while we expect it to fall in the latter scenario.

The small deal in either of the two main scenarios would probably also share some similarities: The employee payroll tax will likely expire and reset to 6.2% from currently 4.2% Both Obama and Romney have voiced their preference to lower the corporate tax rate, although we expect it to fall by more in the Republican control scenario. Debt-financing tax exemptions such as deducting mortgage taxes from income would likely be lowered in both main scenarios Social security and unemployment benefit spending as a percentage of GDP would likely stay roughly the same in both scenarios Emergency unemployment benefit spending would likely expire The doc fix would likely expire in both scenarios

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Fig. 8: Most likely outcomes under both political scenarios

Note: a + means higher, a + + means significantly higher than in 2011, similarly a means lower, a means significantly lower than in 2011 Source: CBO, and UBS

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Asset class impact assessment

To assess the impact of the five main scenarios on asset markets, we rely on the respective scenarios implications on two dimensions (see Fig. 9). The first is the amount of fiscal drag on US GDP growth that occurs in 2013. The second is the amount of policy uncertainty that hits in business and investment community during the first half of 2013. Here, a key factor is whether a credible longer-term deficit reduction strategy is adopted. Generally speaking, the cliff is the worse scenario on both measures, while the Grand Bargain is the most favorable. The other scenarios can be considered intermediate outcomes.

Fig. 9: Impact assessment matrix

High Policy uncertainty Pothole and kicking the can Kicking the can Pothole with Grand Bargain Grand Bargain Fiscal drag on 2013 growth Low
Source: UBS

Cliff

Low High

Fig. 10: Impact assessment matrix

Source: UBS

Equities The resolution of the fiscal cliff and the outcome of the November elections could have important implications for equity investors. As we have laid out in our prior reports, our view of US equity markets is moderately constructive. In our view, the impact of the fiscal cliff and the election can be divided into two areas: the outlook for earnings and earnings growth the impact on valuation multiples (which are a function of interest rates, investor perception of risk, and taxes, among other things)

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Below we lay out how these variables might change in the scenarios we identified in Figure 4. The fiscal cliff is clearly the worst scenario for markets, though also the least likely in our view. In this scenario, earnings estimates would certainly fall. In the average recession earnings fall about 15-20% (for perspective earnings fell by 45% in the financial crisis). If we assume earnings decline at a mid-teens rate we could be looking at an earnings estimate of USD 90 by mid 2013, i.e. 17% below our current expectation. But this outcome is highly unprecedented and therefore uncertain. History may not prove to be a good guide and there could be downside to estimates obtained through such rules of thumb. When earnings decline, valuation multiples almost always decline as well. In this case the market multiple would also have to contend with highly dysfunctional policy, a likely downgrade to the US credit rating and higher taxes on capital. In this uncertain environment a fair market multiple could decline to a range of 11-12x, which could drive the S&P 500 to a range of 1000 1100, or up to a 25% decline from current levels. Under such a scenario we would expect international markets to suffer similar losses. In particular, we would expect eurozone and emerging market equities, the more cyclical regions within global equities, to decline by a similar order of magnitude in response to this US-based shock. Other main regional equity markets are likely to decline by less. In our view, the fiscal pothole and kicking the can scenario is closest to current market expectations and therefore has the smallest impact on equity markets. In this case our earnings expectations would likely remain unchanged. The impact on the market multiple would also likely be fairly modest. The long-term deficit issues would likely remain unresolved as would the uncertainty around long term tax and spending policies on a large number of items, both of which would tend to keep the market multiple lower than normal. We can foresee this pothole scenario playing out under either an Obama or Romney administration so it is hard to generalize about tax rates. Under an Obama victory tax rates on dividends and capital gains would likely rise, especially for the highest earners. While this could depress the market multiple it is important to bear in mind a few things about taxes. First, many investors are already expecting higher taxes on capital (which is part of the reason that the current market multiple is lower than normal). Second, pension funds, endowments and individual retirement accounts are shielded from dividend and capital gains taxes so their behavior will not change if tax rates go up. Third, ordinary income tax rates

Fig. 11: US fiscal cliff in 2013

Probability 4 3 2 Geographic scope 1 0 Intensity

Imminence
Source: UBS, as of 25 June 2012

Legend to Fig. 11
1
Probability* Intensity** Imminence*** Geographic scope****

2 10-20% medium 9m high

0-10% low 12m medium

20-30% 20-30% high 6m very high very high 3m global

Explanation Risks are assessed along 4 dimensions: * of occurrence within the upcoming 12 months. ** Global market impact, (average absolute impact on asset classes). *** Market impact is likely to start within a three-, six-, nine- or 12month horizon. **** Number and significance of regions affected

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would likely rise also so stocks may not have a relative disadvantage versus interest income on bonds. Under a Romney administration taxes on capital gains and dividends would likely remain at current rates. While some investors might view this as a positive outcome, we are more skeptical. With uncertainty about long term budget sustainability remaining, we believe investors would not view these rates as permanent and any expansion in the market multiple is likely to be minimal. The fiscal pothole and Grand Bargain would be a fairly positive outcome for equity markets. However, with only a partial extension of some of the expiring provisions, markets will first have to contend with some elevated uncertainty in December and January; similar to the outcome in scenario one. Yet, ultimately an agreement to put the US on a sustainable fiscal path would clear up some ambiguity and lead to an expansion in the market multiple. Under this scenario we think a fair multiple would be 14x, still a bit lower than longer term averages because growth is still likely to be slower than normal (consumers and government will be deleveraging) but investors will likely cheer the greater certainty around long term tax and spending policy and the elimination of the threat of further downgrades to the US credit rating. In this scenario, earnings will not likely be too different from our current expectations, although it is possible that greater fiscal certainty drives both businesses and consumers to begin deploying their cash via a ramp up in investment spending. Because investment spending is an important driver of profits, our 2013 earnings estimate could prove to be conservative. Nonetheless it is important to bear in mind that profit margins are already at peak levels and earnings are slightly above trend so the increase in earnings expectations would probably be modest. Still, this would be positive relative to current market expectations. This scenario is most likely under a Romney victory because Republicans will likely hold both chambers of Congress and the White House, making it easier to implement long term reform. As a result, taxes on dividends and capital gains will likely remain low, and coupled with a long term fiscal deal, the likelihood that these tax rates are permanent rises. This would also tend to boost the market multiple. In the kicking the can (without pothole) scenario, we would expect no significant setback in late 2012, early 2013, as policies are extended. However, markets would remain choppy thereafter, given a lack of resolution of longer-term fiscal problem. Returns would be driven mainly by sluggish earnings growth, rather than any meaningful multiple

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expansion in this case. Finally, in the Grand Bargain (without pothole) scenario, a resolution to policy uncertainty would lead to multiple expansion. Moreover, stronger economic and earnings growth would further support a rally in equities. This is clearly the most market friendly scenario. Fixed Income Under a fiscal cliff scenario, we would expect to witness a classical flight to quality with US Treasuries rallying, while widening credit spreads would adversely affect credit-sensitive fixed income market segments such as corporate bonds or emerging market debt. The high recession risks under this scenario are likely to lead the Fed to adopt a more expansive monetary policy, which could turn into a further source of support for Treasuries. One possible exception to this pattern could occur if the political stalemate that would allow the cliff to materialize in early 2013 without retroactive legislative action in the first quarter were so large that no agreement were reached on increasing the debt ceiling. This would be the most disastrous version of the fiscal cliff, which we deem unlikely even if no other elements of an agreement are reached. The ensuing technical default on Treasuries could break traditional market dynamics and lead parts of the Treasury curve (in particular the front end) to sell off. Under the fiscal pothole scenario, we would expect that economic uncertainty and growth risks would keep Treasuries well-bid with 10-year yield remaining below 2%. The medium-term outlook would be dictated by the size and credibility of any fiscal deal. In the Grand Bargain scenarios, yields would likely rise, but only modestly. Credit risk would remain off the radar and have no effect on yields. Better prospects for business spending would be offset to an important extent by the demand curbing effect of fiscal tightening prompting a continuation of expansive monetary policy. In the kicking the can case, the lack of a credible longer deficit-reduction plan in the US and the associated rating downgrades are likely to exert upward pressure on Treasury yields as investors start to price in some element of credit risk and possibly inflation risk. However, we would expect such a trend to be very muted. Indeed, in a world where risk-free assets are become increasingly rare, debt instruments with the liquidity advantage of US Treasury paper will likely remain in strong demand largely offsetting credit risk concerns. Longerterm inflation risks will likely rise in the absence of a large fiscal deal as the Fed might feel under increasing pressure to monetize public debt. Such effects are unlikely to have

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meaningful market effects and would only be felt in the out years after inflationary pressures have picked up. Foreign Exchange We believe that scenarios in which fiscal belt-tightening occurs in a too little, too late fashion (i.e. the kicking the can scenarios) are likely to see the USD weaken on a broad basis. In contrast, scenarios involving a Grand Bargain would be dollar-positive. The future value of the US dollar depends crucially on the political response to the approaching fiscal cliff. Important foreign investors in US Treasuries such as the Chinese Central bank, other Asian monetary authorities, Middle Eastern sovereign wealth funds and others are closely monitoring US plans to reign in public deficits. They are also observing the mix of monetary and fiscal policy and its effect on the current account deficit. Any half-hearted program that does not lead to significant fiscal consolidation will increase these investors incentives to recycle the existing stock of debt into non-dollar assets. Such selling pressure will weaken the USD. Potentially significant reactions of currency markets to US debt-related issues will eventually arise, because, foreigners have accumulated large amounts of USD debt over the last 10 years. Moreover, because the US runs a large current account deficit, it must issue new debt to foreign investors on an ongoing basis. This undermines the value of the dollar in the longer term. In a fiscal pothole scenario that is not followed by a large fiscal package for the next decade, we expect the USD to weaken again versus other major currencies. However, in the pure fiscal cliff scenario, in which no deal is reached in early 2013, we expect the dollar to strengthen as the ensuing recession and associated flight to quality would create a demand for dollars. A recession would also support the US dollar as a rising unemployment rate would increase the private savings rate and reduce the demand for foreign goods. In particular the demand for oil would shrink and reduce the current account deficit. Thomas Flury, analyst, UBS AG Commodities: US fiscal cliff - a real threat to commodities A fiscal cliff and the associated contraction in US GDP would bring broadly diversified commodity indices, like the DJ UBS, down by around 25% and push the DJ UBS spot index below the 2010 lows. The most affected sector should be energy, which is already battling ample availability of supply. Our expected 0.15 mbpd (0.8%) US consumption increase for crude oil in 2013, would turn into a 0.35 mbpd drag. Now

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combining these demand-side considerations with a 0.4 mbpd increase in US supply, WTI would likely reach USD 55/bbl and Brent crude would touch USD 68/bbl. Other energy sources, like US natural gas would dip below USD 2/mmbtu again and US thermal coal prices would slip below USD 48/ton. While the US impact on energy is very direct, due to the country's large global crude oil share, the impact on base metals goes via China. With Chinese investment and industrial production expanding at only low single-digit rates, commodities like copper would close in on USD 5400/mt. Also negatively affected by the general drop in asset prices and investor's search for liquidity would be gold. That said, with prices only sliding to USD 1400/oz, the metals decline would be temporary as the likelihood of quantitative easing by the Fed would rise dramatically in a cliff scenario. In the case of a fiscal pothole, in which the US economy slows but avoids a recession, the impact of sluggish economic growth on commodities would rather be neutral. For crude oil demand, however, it would be insufficient to outpace incremental supply. But also gold could perform well in such an environment. As the USD would be under pressure and investors fear over a possible US credit rating downgrade, investment demand could get a lift. Dominic Schnider, analyst, UBS AG

Asset Class impact of main risk scenario (major risk in case of several risk scenarios)

Risk Factor

Likelihood
Current Previous
EM U Equities US equities

Impact Equities
EM equities UK equities Swiss Equities

Fixed Income
Corp. Bonds IG Corp. Bonds HY Gov. Bonds DM Gov. Bonds EM

Currencies
EM currencies

Commodities
Base metals Precious metals

RE
Listed Real Estate

Risk Scenario (<10%): Huge fiscal tightening ("fiscal cliff") in 2013

n.a.

20-30%

Energy

USD

CHF

EUR

Probabilities:

<10%

10-20%

30-40%

>50%

Impact ranges from +++ (very st rong posit ive impact ) over n (neutral) to --- (very st rong negative impact ). Impact direction: - expected drawdown (EDD); + expeced " draw-up" (EDU) n neut ral; n.a. not available Impact scale: '-' represents EDD < -10%for Equities, FX and commodities and ED < -5%for bonds - any additional '-' works as a multiplier. For '+' we use the same scale t o t he upside

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Appendix
Global Disclaimer
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Wealth Management Research 26 June 2012

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