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UBS research focus -Outlook 2006

Zurich / Basel | | Media Releases Switzerland

The year ahead will see a further slowdown in US growth. Neither the Asian economies nor Europe, with its depressed levels of consumption, will manage to escape this trend completely. However inflation risks will remain limited in an environment of more stable oil prices, signalling that a new interest rate plateau has been reached. Thus the risks in the financial markets should remain calculable. We expect bonds to offer slightly below-average yields. On the other hand, equity market valuations indicate that an adequate year can be expected for equities on average, with mostly single-digit returns. However, major bouts of market uncertainty and declines during the year cannot be completely ruled out.

Economy: slowdown in US growth to continue
Despite the devastation wrought by successive hurricanes, the US economy held up well in 2005 with growth of around 3.5%, although lower than posted in 2004 (4.2%). Private consumption continued to be the mainstay of growth, but we expect this demand component to weaken in 2006. Although consumer spending has been supported by both solid employment growth and further rises in wages and salaries, the savings ratio of US households was still negative in Q3 2005. As personal income was not sufficient to finance private consumption, this meant that households were forced to dip into their savings. In addition, a major source of household income, from remortgaging or increasing existing mortgages, will dry up during the year in light of higher interest rates and a gradual slowdown in the housing price boom.

Economic growth in Asia again exceeded the global trend in 2005. China once again closed the year with GDP growth in excess of 9%, while Japan - despite a weak start to the year - posted growth of around 2%. Even though intra-Asian trade is still gaining importance, we do not believe that the region can decouple from weakening US growth. One of the primary reasons for this is that a significant part of intra-Asian trade involves intermediate rather than end products.

The three largest economies in the euro zone gained little or no momentum in 2005. Italy is likely to have stagnated during the year 2005 and France will probably have been adversely affected by the civil unrest, while we expect growth of only about 1% for Germany. Although the economic indicators brightened somewhat in Q4 across the continent in general, Europe still does not look as if it is really gathering momentum. Reasons for this include the weak growth of private consumption and sensitivity to expected interest rate rises.

Bonds: yields reach new plateau
Yields ended the year higher, particularly in the US. But fluctuations were extremely wide during the year. European yields, too, moved sharply off their lows in mid-2005, though they are still below their fair equilibrium values. Against this backdrop, further rises in yields are in the cards this year. However, the expected slackening in US growth momentum and the limited inflation risks suggest that yields have peaked in the US. The expected growth in private saving will also keep long-term yields in check. On balance, we expect long-term yields (10-year government bonds) to approach 5% at times in the US and to edge only slightly upwards towards 3.7% in Europe.

Equities: cyclical risks limited by fair valuations
2005 was a very good year for equities in many regions of the world, with the prominent exception of the US, where the market had already discounted very positive expectations. As we had anticipated, the European equity market therefore lost some of its valuation advantage over the US. The global economic slowdown, a slight rise in yields and a noticeable flattening of the earnings curve indicate an environment that is not fundamentally favourable for equities in 2006. But as share prices reflect very cautious assumptions, the potential for unpleasant surprises is limited. And the expected end to US monetary tightening during the year may be the catalyst for a rise in equity markets. In addition, our models confirm that US equity valuations are fair even on conservative earnings assumptions. This means that investors may expect an adequate year, with single-digit returns for the most part. We believe that valuations for the euro zone and the UK will remain favourable, possibly with above-average potential returns in the long term. Equities therefore remain an attractive asset class, despite the harsher business climate. However, the higher risks will demand more patience and nerve from investors, and sizeable setbacks in the markets cannot be ruled out during the year.

Currencies: flagging growth depresses US dollar
The US dollar is still feeling the drag of the high current account imbalance between the US and its trading partners in Asia and the Middle East. The expected slowdown in US consumption, a lack of financial discipline and inflation concerns are other factors adversely impacting the US dollar. As diversification currencies, the euro, pound sterling, Australian dollar, Canadian dollar and Swiss franc should benefit from US dollar weakness. China's slowly ebbing resistance to a revaluation of the renminbi against the US dollar favours investments in other safe currency areas. The highly-sophisticated Japanese financial market presents additional risks, however, as the end of deflation draws near. The process of transition away from an expansionary stance in support of the economy to a policy of tighter budget discipline has the potential to trigger greater currency volatility.

Non-traditional asset classes: still valuable as portfolio additions
Last year, taking on risk in the financial markets continued to pay off. Emerging market bonds and equities yielded excellent returns as these markets benefited from current account surpluses and from good global economic demand overall. In Europe, corporate bonds, particularly those with lower credit quality, also outperformed government bonds. It cannot be assumed that this situation will continue in 2006 in a climate of increased cyclical risks.

Returns on real estate and commodities, which have topped the performance list over the past few years, will also probably see a more modest, but still positive trend. While commodities will stay at a high level because of solid demand and limited supply capacities, real estate equities will profit from stable commercial property prices and high dividend yields. Hedge funds, which performed well in 2005 with returns in excess of 7% in US dollar, are also likely to have a stabilizing effect on investment portfolios in a year of increased market volatility.

Contact:
Alex Kobler, Head Global Investment Strategy, UBS Wealth Management Research
Tel. +41-44-234 59 43

Economic forecasts
GDP growth in %

2004

2005

2006

2007

USA

4.2

3.4

3.0

2.0

Canada

2.9

2.8

3.0

2.5

Australia

3.6

3.0

3.0

3.0

Japan

2.6

2.0

2.0

2.0

EMU

1.7

1.3

1.6

1.4

Germany

1.6

1.0

1.3

1.4

France

2.1

1.6

1.7

1.6

Italy

1.0

0.3

0.9

0.5

Spain

3.1

3.3

3.0

2.5

Netherlands

1.7

0.5

1.6

1.9

UK

3.1

1.7

2.4

2.3

Sweden

3.1

2.3

2.8

2.6

Switzerland

2.1

1.9

2.0

1.3

China

9.5

9.2

8.5

8.2

Asia1

6.0

6.7

6.4

4.5

Latin America

6.0

4.0

3.8

3.2

Central/Eastern Europe

6.2

4.9

4.6

4.4

1 Excluding Japan

UBS WMR forecasts

Economic forecasts
Inflation in %

2004

2005

2006

2007

USA

2.7

3.1

3.4

2.7

Canada

1.8

2.0

1.8

1.5

Australia

2.2

2.5

2.5

2.0

Japan

-0.1

-0.1

0.2

0.4

EMU

2.1

2.2

1.8

1.5

Germany

1.6

1.9

1.5

1.0

France

2.1

1.8

1.5

1.8

Italy

2.3

2.1

1.9

1.5

Spain

3.0

3.3

3.0

2.6

Netherlands

1.4

1.5

1.3

1.6

UK

1.3

2.1

2.2

1.8

Sweden

0.5

0.6

1.4

1.9

Switzerland

0.8

1.1

0.6

1.1

China

4.0

2.5

2.3

2.0

Asia1

3.3

3.5

3.5

3.3

Latin America

7.3

6.0

6.4

5.8

Central/Eastern Europe

8.6

7.4

7.2

6.5

1 Excluding Japan

UBS WMR forecasts

Interest rates

3-month LIBOR

10-year govt bond

mid 06

end 06

mid 06

end 06

USD

4.50

4.25

4.70

4.50

EUR

2.30

2.30

3.60

3.70

JPY

0.10

0.30

1.80

1.90

GBP

4.60

4.60

4.40

4.40

CHF

1.30

1.25

2.30

2.50

AUD

5.50

5.50

5.50

5.50

CAD

3.60

3.60

4.30

4.50

SEK

2.10

2.40

3.30

3.60

Zurich / Basel, 5 January 2006
UBS