Deflation Ubs June 2010

Philippe G. Müller, CIIA, analyst, philippe-g.mueller@ubs.
com, UBS AG
Dirk Effenberger, strategist, dirk.effenberger@ubs.com, UBS AG
Wealth Management Research 11 June 2010
Deflation-inflation knife-edge
Updating our investment strategies for deflation
Selected related publications
■ Although not our base case scenario, we examine the potential impact
of a prolonged period of deflation on various asset classes. We also ■ Deflation-inflation knife-edge: Corporate
suggest investment strategies suitable for those who expect such an bonds facing inflation, 10 February 2010
extended period of falling prices.
■ Deflation-inflation knife-edge: Strategies to
■ For equity investors, we think shares of companies with proven pricing meet a surge in inflation, 15 September 2009
power, solid balance sheets and good regional diversification may be
attractive.
■ Extending the average portfolio duration and a careful selection of Table of contents
bonds can also help preserve purchasing power. The fine print relating Economics 2
to embedded deflation floors should also be well understood by Liabilities 3
investors in inflation-linked bonds. Fixed Income Investments 4
■ While cash seems to be king and liabilities are less welcome, investors Currencies 6
are well advised to understand the FX landscape since deflation Equities 8
promises to trigger some bouts of high volatility on this market. Hedge Funds and Private Equity 9
■ Other asset classes, such as hedge funds or commodities, are also Real Estate 10
examined in this note and we highlight how important selectivity Commodities 11
becomes in a persistent deflationary environment.
On the cusp Fig. 1: WMR inflation expectations

Economic opinion is divided, and this makes life difficult for some investors. In percentage points
In the aftermath of the financial crisis, do we face an era of inflation or
deflation? Investors need to know how best to position themselves in either
case. In this paper, we now take a close look at the investment implications
of a deflationary scenario after having shed some light on the consequences
of inflation in an earlier publication.
Although we think it is less likely to unfold than an inflationary environment

(Fig. 1), we cannot dismiss the emergence of deflation altogether. For
investors who think deflation is inevitable in the coming years, we outline
some strategies for preserving wealth in what would prove to be a
challenging environment.
Source: UBS WMR, Reuters Ecowin, as of 07. June 2010
This report has been prepared by UBS AG.

Please see important disclaimers and disclosures that begin on page 13.
Past performance is no indication of future performance. The market prices provided are closing prices on the respective principle
stock exchange. This applies to all performance charts and tables in this publication.
UBS Wealth Management Research 11 June 2010
Economics — Defining deflation

Inflation is commonly understood as a persistent rise in the general level
of prices, while deflation is a sustained drop in prices as measured by the
consumer price index, for example. The emphasis here is on the words
"sustained" and "general." Clearly, prices falling for a few months would
not constitute much of a problem. Likewise, at any given time, prices of
some goods and services will fall, reflecting changes in demand and supply.
Painful as this may be for the sectors and industries that have to cut prices
in response to weakening demand, this is not what we mean by deflation.
In fact deflation has two faces: There is "good" deflation that results
from more efficient and thus cheaper means of production (think: flat
th
screen TVs). This type of deflation prevailed for much of the 19
century, accompanying strong economic growth. But there is also "bad"
deflation, which is associated with a deep, dark economic recession. In this
form, overall economic conditions are such that declining prices reinforce
expectations that prices will fall even further in future. This prompts
consumers and businesses to postpone purchases, only aggravating the
drop in total demand that has caused prices to weaken in the first place.
The cause of pernicious deflation is said to be a collapse of aggregate

demand, a drop in spending so severe that producers across all sectors
must cut prices on a sustained basis in order to find buyers for their
products. Following the great recession of 2009, demand has been
successfully propped up by the massive fiscal and monetary stimulus
programs implemented by governments worldwide.
Today, there are concerns that the world's economy may slip back into
recession – the W-shaped "double dip," as it is called – as soon as
government support is reversed. It is a fact that a looming sovereign debt
crisis has already prompted many governments, especially in Europe, to
announce tough fiscal austerity programs. On the other hand, we think
that monetary policy may remain loose for longer than currently anticipated
in order to counterbalance the burden of tighter fiscal policy.
We contend that, in the longer-term, inflationary pressure may be the

bigger problem. However, deflation risks cannot be dismissed out of hand
and investors are well advised to contemplate its consequences. Before
looking at the implications of deflation for different asset classes, we
highlight one specific and profound economic consequence: Deflation
actually increases the real value of debt.
Consider a loan of USD 1000: If prices drop 3% per year for 10 years, the
nominal repayment sum at the end of that period would be worth more
than USD 1,340. In contrast, 3% inflation would have lowered the value of
the loan to only USD 737. Thus, deflation is bad for borrowers. On the other
hand, it is good for savers. Their thrift is rewarded well beyond any nominal
interest gains they may receive. In short, deflation discourages borrowing
and encourages saving. This single effect of deflation has consequences for
virtually all asset classes, which we will consider in detail in the following
sections
Dirk Faltin, Economist, UBS AG
Deflation-inflation knife-edge - 2
Managing assets and liabilities in Fig. 2: Energy-driven swing in headline inflation

Core inflation more stable (% y/y rates)
deflationary times
We have outlined the consequences of inflation on an investor’s asset
and liability management in a previous paper. We concluded that higher
inflation is generally positive for debt holders, all the more if they have been
able to finance their debt with long-term fixed-rate loans when inflation
(and therefore interest rates) was still low. But in the case of a prolonged
period of deflation, this dynamic is reversed.
Deflation is good for savers (or holders of cash) and bad for debtors, as we
have seen. The various forms of deflation will affect the balance sheet of a
private household or a company in different ways. Deflation in the form of
falling consumer prices will increase the real value of debt, as noted above.
If deflation is protracted, not only will consumer prices fall, but typically also
Source: ThomsonReuters EcoWin, UBS WMR, as of 06. June 2010
wages. Thus, the "real" (inflation-adjusted) burden of a private household's
debt increases as its ability to pay for interest fees and amortization shrinks
with its falling wage income.
Usually, in a deflationary environment it is not only consumer goods and

services prices which fall, but also asset prices such as equities or real estate.
Falling real estate prices diminish the home equity position of a private
household and one can even end up in a situation where home equity is
negative, i.e. outstanding mortgage debt is higher than the value of the
home.
Implications for investors are straightforward: If deflation is anticipated with

high conviction, a rational approach would be to start paying down debt,
either by selling assets that are likely to fall in value anyway in a deflationary
environment or through retained income. If debt cannot be completely paid
down, it should be financed with short-dated loans since central banks
usually cut interest rates all the way down to zero in a prolonged period of
deflation, driving short-term loan rates below those for longer-term loans.
Daniel Kalt, Economist, UBS AG
Fixed income investments and deflation Fig. 3: Deflation vs. bond yields in the US
In percentage points
The underlying trend of consumer price inflation is critical for any bond
16 18
investment. Market prices and yield trends for government bonds are 14 16
closely linked to changes in inflation expectations. If consumer price 12
14
inflation is expected to decline, yields tend to decline and prices for 10

12
nominal government bonds tend to rise. It is important to note that 8

10
6
expected and not actual inflation is the driver here. However, the latter can 4
8
impact the former as inflation expectations tend to be adaptive. Thus, the 2

6
developments of yields is not only correlated to inflation expectations, but 0

4
also to actual inflation (Figure 3). Therefore, nominal government bonds (2) 2
(4) 0
would be one of the main beneficiaries of a prolonged period of falling 1977 198 1985 1989 1993 1997 2001 2005 2009
US CPI (lhs) 10-year treasury yields (rhs)
prices, that is, deflation.
Source: UBS WMR, Reuters EcoWin as of 07 June 2010
Nominal government bonds preferred

The market's inflation expectations can be broadly inferred from the
difference between yields on nominal government bonds and those on
real or inflation-linked bonds (ILBs) of a similar maturity. Chart 4 shows
that the market shifted from a deflation towards an inflation scenario in
2009. However, since early this year markets have revised their inflation
Fig. 4: Market’s inflation expectations
expectations sharply downward and now project inflation to remain below
In %, calculated as the difference between yields on
its long-term average over coming years in major countries. For example,
5-year nominal and 5-year real inflation-linked bonds
the market thinks consumer price inflation in Germany will remain below
the ECB inflation ceiling of 2% over the next five years.
What if there were in fact a lengthy period of unexpected deflation,

with consumer prices falling significantly? Experience suggests that if
consumer price inflation were to be lower than breakeven inflation over
a given period, nominal government bonds would be more attractive
than inflation-linked government bonds. Similarly, if an investor expects
deflation, nominal government bonds should be preferred over inflation-
linked bonds.
Considering corporate credit

We think it useful to differentiate within nominal bonds. Credit quality
becomes an important factor in times when risk aversion is likely to revive, Source: UBS WMR, Reuters EcoWin as of 08 June 2010
driving credit risk premiums higher. Companies with considerable amounts

of (fixed) debt on their balance sheets are likely to have difficulties paying
it down quickly if business volumes and cash flows fade. Hence, many
bond issuers with lower credit ratings see their credit metrics detriorate in a
period of prolonged deflation, and the prices of their bonds may well suffer
more than they could benefit from falling government bond yields. As a
consequence, we would avoid the high-yield bond segment. Instead, we
would move up the rating scale as credit default rates might not drop to
levels seen in previous credit cycles.
Therefore, credit issuers that benefit from guarantees (supranationals,

government-guaranteed agencies, some local governments, etc.) should
do well, in our opinion. And since deflation is not likely to be a global
phenomenon, regionaly well diversified issuers of corporate credit who
enjoy pricing power – the ability to maintain their prices at higher levels –
and who have good cost control should perform better given their more
stable cash flows. Industries with inelastic demand include health care, food
and to some degree utilities. We woud prefer higher-rated credits of these
segments to cyclical sectors and capital goods since delayed investment
activity is likely to hurt such companies.
The potentialy lower liquidty of corporate bonds is also an important aspect

to consider in a prolonged deflationary period. In an environment of lower
growth with incentives for corporations to pay down debt rather than
refinance debt, new issuance could decline and net activity could be flat to
negative. Investors should therfore be prepared to hold bonds to maturity
in some segments.
Inflation-linked bonds can still shine during deflation

Under certain circumstances, inflation-linked bonds (ILBs) can perform well ILBs in different regions
in a deflationary environment. The "deflation floor" of some ILBs can
ILBs offer a real coupon that is constant over
work in their favor, for example. This floor determines that the redepmtion
the life of the bond. In addition, the principal is
amount at maturity cannot be lower than the nominal value at the time
adjusted for increases in the reference price index.
of issue, even if consumer prices have declined over the period. The floor
Thus, coupon payments compensate for inflation,
acts as nominal capital protection (not issuer protection!) at maturity. If
which helps an investor maintain overall purchasing
consumer prices were to fall over the entire term of a newly issued ILB, at
power. For more details, see our Education Note:
maturity the investor would not receive the inflation-adjusted value, but
“Understanding Bonds, Part 8 – Inflation-linked
rather the bond's nominal value at issue. Accordingly, the real yield is higher
bonds.”
than the real coupon on the bond as set at the time of issue.
Deflation
Market Reference Index Coupon
Mind the gaps in the deflation floor Floor*
US TIIPS All Items consumer Yes Semi-annual
ILB's are not without pitfalls. For one thing, not all issuers have bonds with Price Index for all
deflation floors (see Table). Secondly, this deflation protection only kicks in Urban Consumers
(CPI-U)
at maturity. This means that during the term of the bond, its nominal value UK Treasury Gilt I/L Retail Price Index (RPI) No Semi-annual
may drop below its level at issue and, during this period, can be sold only
at a loss on the invested capital. French OATie Euro-area Consumer Yes Annual
Price Index, excl.
tobacco (HICPx)
In any case, we note, protection against deflation comes at the price of a
Germany I/L Euro-area Consum-er Yes Annual
lower real yield to maturity. Finally, the protection depends on the timing of Price Index, excl.
the issue. If a bond were issued years ago and, due to inflation, its inflation- tobacco (HICPx)
adjusted nominal value is now well above that nominal value at issue, then
the deflation floor may not be effective. It will only kick in if, during the Inflation-linked bonds (ILBs) and products like
residual term to maturity, prices fall by more than the cumulative inflation inflation swaps and inflation-linked structured notes
to date. Investors with a strong deflationary view should therefore focus on are the most direct types of investment to protect
recently issued bonds with a deflation floor. against an increase in consumer prices. In contrast
to nominal bonds, ILBs pay a fixed real coupon plus
In sum, investors expecting an extended period of falling prices can compensate for rising consumer prices by adjusting
generate a positive return by investing in nominal government bonds and the bond’s nominal value for inflation.
thus hope to increase purchasing power. With respect to inflation-linked Source: UBS WMR
bonds, investors should prefer recently issued ILBs with an embedded
deflation floor. Similarly, with other variable (nominal) rate bonds – such
as floating rate notes – investors worried about deflation should prefer
products with an embedded interest rate floor.
Dirk Effenberger, Analyst, UBS AG

Philippe G. Müller, Analyst, UBS AG Fig. 5: Steepness of the US interest rate curve
Difference between 2- and 10-year rates
Inverse floating rate notes and curve positioning 3.5

US 10 year - US 2 year
Generally, an economic environment associated with deflation leads to 3
lower interest rates. In an ordinary interest-rate cycle, long-term interest 2.5
rates first fall in anticipation of lower inflation as investors accept lower 2
compensation. To limit deflationary pressures and ensure gradual price 1.5
1
increases over the medium to long term, central banks try to counter
0.5
falling inflation by lowering interest rates, thus stimulating consumption via
0
cheaper credit. Normally, lower interest rates have positive consequences
-0.5
for fixed-income investments: already issued ordinary bonds with fixed -1
coupons rise in value, since only lower interest rates are available in the 1986 1989 1992 1995 1998 2001 2004 2007 2010
market compared a pre-existing bond's fixed coupon. Source: UBS WMR, Reuters EcoWin as of 07 June 2010
An inverse floating rate note (FRN) is even better protected against falling
yields and deflation, as its coupon is adjusted to the new interest rate
environment at each coupon date and rises if the Libor rates decrease.
It is crucial to distinguish between theory and practice when investing.

Generally, inverse floating rate notes profit from lower Libor. Today's
historically low central bank rates do not offer much potential for lower
rates. This is especially the case for the US, UK and Switzerland. The Federal
Reserve Bank, the Bank of England and the Swiss National bank have
slashed their central bank rates to 0.25%. Given the recent debt turmoil
in Europe, Libor has increased by 10 basis points since the end of 2009.
Accordingly, three-month Libor traded at 0.4% in the US and at 0.72% in
the UK on 7 June. In Switzerland Libor slipped to 0.1%. Even though Libor
increased slightly, they remain at a historically depressed level, with limited
potential to decrease further. Thus inverse floaters make little sense in the
current low interest rate environment.
Even though yields across the whole interest rate curve are currently at
historically low levels, the difference between long- and short-dated bonds
is still considerable. This means that the interest rate curve is historically
steep in the US, the UK, and the EU and also very steep in Switzerland.
In anticipation of future deflation or substantially lower inflation, investors

should expect the current very steep curve to change shape, primary
driven by movements at the long end of the curve. Usually, when market
participants expect inflation to fall, investors observe an initially flattening
of the yield curve. This is equivalent to a narrowing of the interest rate
spread of long- and short-term yields. This flattening could, over time, even
result in an inverse interest rate curve, where short-dated bonds would pay
higher coupons than longer-dated bonds.
In the current interest rate environment, with its very steep yield curve, we
think investors expecting a deflationary environment over the next years
should favor investments in long-term rather than short-term bonds in
order to lock in the higher yields (see Fig. 5). In a portfolio context, they
may consider extending the average duration of their bond allocation.
Daniela Steinbrink-Mattei, Economist, UBS AG
Currencies — Deflation promises chaos

Analyzing deflation's economic impact is complicated, not least because
its mechanisms often defy our intuition, which for most of us has been
formed during periods of normal and or even high inflation. For currency
markets the most important effect of deflation economics is that investors
and companies have high incentives to save and low incentives to spend
or invest.
A typical cycle suggests that a country entering deflation will first face
an appreciation of its currency. Deflation typically triggers repatriation,
because the banking system of a country in deflation needs money.
Typically, deflation also means that the real interest rate is much more
attractive than what is available abroad. Also, in deflation, consumer
demand falls, which improves the country's net trade position. In a second
stage of the deflation cycle, the government tries to jump-start domestic
demand and expands government spending. This typically leads to a
depreciation of the currency.
The economic inefficiency of reducing the growth prospects of a country

– and here is just one example of a counterintuitive aspect of deflation
economics – is that the interest rate on simple cash holdings cannot become
negative. In times when prices fall and money stays stable, the investor
receives a positive real interest rate, even when the nominal interest on cash
holdings is zero. Our experience with deflation in Japan in the mid-1990s,
as well as during the latest financial crisis, suggests that the effect of rising
real interest rates is most strongly felt at the outset of the crisis and is later
replaced by other influences, which can be traced back to the reduced
growth outlook for the given country.
The currency cycle of deflation

The effects of deflation on currencies are dynamic, not static. We note three
discreet stages that form the deflation cycle of currencies:
■ The onset of deflation leads to a rapid reduction of credit positions

(deleveraging) and the unwinding of carry trades. This supports low-
yielding currencies (at present, the Japanese yen or US dollar) and
pressures high-yielders (currently those of emerging markets and
commodity producers).
■ Persistent deflation keeps real interest rates high and the currencies
of countries with the strongest deflation experience the sharpest
appreciation.
■ Eventually the countries where deflation is strongest will see their
economic strength reduced, leading to a depreciation of the currency
that is often accelerated by reflation policies as governments spend
unusually high amounts of money to revive their stricken economies.
In short, deflation promises chaos on currency markets. In the first phase,

low-yielders and the currencies of countries with strong deflation tend to
appreciate due to repatriation of capital and deleveraging. In the second
phase, the currencies of the deflation countries tend to depreciate sharply
as growth prospects decline and the need for government intervention
increases. A vicious cycle, indeed.
We identify two disruptive processes at work in this cycle. One kicks in at

the outbreak of deflation and the other is at work in the transition from
the second to the third stage. Both processes are highly disruptive and the
shift in currency valuation at these stages can be very large. We also note
that while deflation is never supportive for a currency in the long term, the
possibility of short-term spikes should not be ignored, because they can be
tremendous.
The most likely candidate for a deflationary cycle is Japan, which is

almost half the way through it. Its currency appreciated as inflation rates
entered negative territory. We are now awaiting the second stage, an
even more expansive monetary/fiscal policy, hurting the Yen further. The
next candidate for a deflation cycle is Europe, due to the fiscal austerity
measures. These measures are likely to weaken import demand but improve
competitiveness and therefore strengthen the euro again. Finally, the US is
also not fully protected against a deflationary cycle. The strong appreciation
of the USD this year signals that future appreciation potential is limited,
however.
Thomas Flury, Economist, UBS AG
Equities — Diversification is key Fig. 6: Pricing power sectors fare better in

deflation
10-year performance of MSCI Japan sector indices
The historical examples of equity returns during prolonged periods of
during
deflation are very rare. The most prominent example is probably Japan
during the last decade, with a few exceptions. The consequences of 350
deflation for equity market returns are intimidating. However, if real
300
purchasing power of money increases, weak nominal returns are somewhat
250
counterbalanced. A closer look at the key drivers of stock returns can
help to identify some less vulnerable companies, which still might generate 200
sufficient returns. From a theoretical point of view, risk premiums tend 150
to rise in a deflationary environment, bond yields tend to fall, making 100
the net effect of deflation on discount rates for earnings less clear. Past 50
deflationary periods have seen earnings fall as a result of lower sales or
0
because purchases are delayed by consumers. Intuitively, equities generated 00 0 02 03 04 05 06 07 08 09 1
weak returns and haven’t been a good hedge against deflation. Health Care Utilities MSCI Japan Energy
However, a few segments of the corporate sector are able to operate Source: Datastream, as of 07 June 2010
even under these circumstances and to show slightly positive earnings

growth. The Health Care sector offers the advantage that their product
demand can't be delayed and that the price sensitivity of their clients is
very low in general. Both factors are almost unique to this industry and
are clear advantages, if the overall economy suffers from deflation. Both
arguments would also apply for the tobacco industry and regulated utility Fig. 7: Only Energy and Utility companies
companies, albeit to a weaker extent. In addition, companies that have delivered positive returns
Annualized JP sector performance over the last 10
strong balance sheets and good credit ratings suffer less from the rising
years
risk premiums effect. They also enjoy better access to capital markets than
weaker companies. Integrated oil companies generally meet these criteria, 10%
for example. 5%
0%
On the other hand, companies with relatively high debt levels and fixed
maturities, and that are also exposed to discretionary consumption would -5%
suffer in a deflationary environment. The auto sector meets both of -10%
these criteria. An additional drag for the car industry is its important -15%
leasing and financing activities. While lower interest rates reduce borrowing -20%
ENERGY
IT
RETAILING
TELECOM
CONS DISCR
HEALTH
FINANCIALS
UTILITIES
INDUSTRIAL
MSCI JAPAN
STAPLES
MATERIALS
costs, higher customer credit defaults in a deflation scenario would add

CONS
CARE
pressure to auto makers' balance sheets. Given the significant profit

contribution of their financial services arms, auto makers would likely suffer annualized sector performance
in a deflationary environment, in our view. Other consumer discretionary

Source: Datastream, as of 07 June 2010
companies would be heavily impacted as well. Both low-end and luxury
goods would be hurt, as purchases are truly discretionary and can be easily
delayed by a couple of years. Therefore, listed companies of such industry
groups are unlikely to deliver superior earnings growth and should be
avoided by investors who expect deflation. The historical performance of
the better performing sectors during the deflationary decade in Japan is
shown in figure 6, and the annualized nominal return of all equity sectors
in figure 7. Another sector that also depends on the overall business cycle
are capital goods companies like machinery producers and aerospace. With
long lead times for production in both segments, it is very difficult to
operate profitably when new orders are delayed and order books shrink.
However, repair-and-maintenance businesses should suffer less, as installed
products are used longer, mitigating the impact of the order shrinkage on
profitability.
So far, we discussed the case of equity in closed economy and capital

market, with no possibility for investors to diversity internationally.
However, especially under the discussed scenario of deflation it would be a
crucial alternative for investors to diversify their equity portfolio into regions
and countries, which have higher inflation and growth rates. We stress
the long term positive outlook for emerging markets, in particular in Asia
and the related investment opportunities for private investors. The region is
likely to experience higher growth rates than developed markets, which will
be accompanied by positive inflation rates as well. Hence, investors should
take advantage of this investment opportunity, especially if their domestic
market suffers from deflation.
To sum up, a deflationary environment would probably be challenging for

most companies. Corporate profits would be under pressure and equity
market returns would be weak as well. Companies with a relative stable
product demand are better positioned to maintain their margins and should
be preferred by investors in a deflationary economic environment. Health
Care, Energy companies, the insurance sector, and tobacco firms exhibit
these characteristics. In addition, international diversification plays a far
more important roll under this scenario.
Philippe G. Müller, Analyst, UBS AG

Oliver Dettmann, Strategist, UBS AG
Hedge Funds and Private Equity

Hedge Funds: If the economy turns deflationary and uncertainty stays
high, hedging strategies in general should continue to produce good
returns when compared to traditional buy and hold strategies. In particular,
investors may want to consider exposure to global macro and equity long/
short strategies. This is particularly true under a scenario where underlying
growth drivers and the pace of growth vary significantly among countries,
with a deflationary environment confined only to certain economies. Global
Macro managers should be therefore able to extract value from fixed
income and FX, based on timing, geographical biases, and large growth
divergences. As we all know, such a divergence was seen between the US
and Japan over the last two decades. Although a deflationary environment
is not good for equities, Long/short equity strategies should benefit from
fundamental analysis as well as trading skills in an environment that allows
positive attribution on both the long and the short side (trading). Moreover,
talented long-short managers can increase their long exposure to dividend
paying stocks providing good adjusted-for-deflation rates of return. In a
prolonged deflationary environment, liquidity in some markets could suffer
(i.e. some bonds segments). Hence we see no reasons from deviating too
strongly from the above mentioned strategies (e.g. global macro). In this
context we also suggest investors to choose products that offer a certain
minimum level of liquidity.
Private Equity: If the deflationary phase is prolonged, we advocate staying

clear from this group. However, if such phase proves short lived, we see it as
good entry point. Investors are also likely to pay down for their investments
as we expect the valuation discount vs. equities is likely to be the greatest
due to liquidity concerns. As economies recover over time, so should
primary offering, acquisition, and private equity valuations, generally. It is
Interesting to note that private companies are preponderantly in the US and
are obviously more dependent on their domestic economy, which should
lead the recovery, and are therefore somewhat less affected by turmoil
elsewhere, in Europe, for instance. Consequently, in most cases the higher
discount (25%-30% premium over equity), is unwarranted in our view.
Cesare Valeggia, Analyst, UBS AG
Real estate Fig. 8: Capital growth and deflation

Deflation expectations in the US and capital growth
in the UK strong correlated(%, monthly)
By assessing whether return oriented real estate investment is a good hedge
against deflation one should formulate expectations about the appropriate
3.5 4
future cash flows and the required discount rates (see appendix for details 3.0 3
on how they are defined) to come to the estimated real estate capital 2
2.5
1
value. The answer also depends on whether a severe, multi-year deflation 2.0 0
1.5 -1
is expected or instead a slight and brief one.
1.0 -2
0.5 -3
In the case of an expected slight and brief deflationary period, discount -4
0.0
-5
rates tend to decrease quite quickly, driven by decreasing or negative -0.5 -6
inflation expectations. Should the short deflationary period not be expected -1.0 -7
02 03 04 05 06 07 08 09 10
to drive the economy into a recession, then one would expect the discount Inflation Expectations Capital Growth (rhs)
rate to decrease faster and deeper than the expected future net operating
income (NOI). The reason is that the future NOI would consequently be Source: IPD, Bloomberg, UBS WMR, as of 07 June 2010
expected to stay stable as the perennial lease contracts are believed to be
enforceable. This in turn would result in growing capital values, while the
overall market related risk premium wouldn't increase at all. We conclude
that an expected slight and brief deflationary period could be positive for
capital values as far as investors do not price a recession in. This case is quite Fig. 9: Income return and deflation
unrealistic in our view as negative inflation expectations normally reflect Inflation expectations (US) and incorme return (UK)
recession fears. inversely linked (%, monthly)
The fact that negative inflation expectations and recession fears are related 3.5 0.8
is best illustrated by the recent developments in UK real estate values. 3.0 0.7
2.5 0.6
First, as a proxy we derive the overall inflation expectations by subtracting
2.0
the 5 year real yield of the US inflation linked bond from the yield 0.5
1.5
0.4
of the closest nominal US treasury maturity. Second, we consider the 1.0
0.3
development of the capital values based on monthly capital growth, income 0.5
0.0 0.2
return and total return figures derived from 75 UK based real estate 0.1
-0.5
portfolios including 4'300 commercial and investment properties, which -1.0 0
are externally appraised on a monthly basis. The growth rates indicate the 02 03 04 05 06 07 08 09 10
Inflation Expectations Income Return (rhs)
change in the month under review compared to the same month a year
earlier.
Source: IPD, Bloomberg, UBS WMR, as of 07 June 2010
Deflation expectations materialized quickly in the fourth quarter of 2008

and were highly correlated with fast decreasing capital values (see
chart). Thus real estate was unable to protect against expected deflation.
Furthermore, the recent real estate crisis, which revealed huge debt
deleveraging needs, is believed to have triggered deflation and recession
Fig. 10: Total Return and deflation
fears. The income return – which is the quotient of NOI and capital value Total returns (UK) negatively affected by US deflation
– grew rapidly (see chart), driven by growing risk premiums and a sharp expectations (%, monthly)
decrease in expected capital values. The premium first reflects the fears that
the lease contracts won't be enforceable and tenants will default or force 3.5 5
the investors to revise lease terms downward. Second, real estate investors 3.0 4
3
may be forced to sell their properties, which in turn could additionally 2.5
2
2.0 1
burden the future capital values. The total return on property (see chart)
1.5 0
- putting together capital growth and income return - was left quite 1.0 -1
negatively affected, thus unable to protect against deflation or even causing 0.5 -2
-3
it. 0.0
-4
-0.5 -5
-1.0 -6
Equity-financed as well as highly leveraged real estate investors are both
02 03 04 05 06 07 08 09 10
affected by deflation expectations by experiencing a deterioration in their Inflation Expectations Total Return (rhs)
asset holdings: future cash flows are estimated to decrease, while the
discount rate doesn't fall enough due to increased uncertainty. The highly Source: IPD, Bloomberg, UBS WMR, as of 07 June 2010
leveraged real estate investors may be forced by their lenders to increase

the equity stake in their investment or to sell the properties, because the
credit quality will be put into question. Furthermore in a severe deflationary

environment, borrowers may be unable to repay their debts since the real
cost of debt repayment may rise sharply. Therefore, properties may be
marketed below their actual value, thus reinforcing a deflation spiral due
to forced sales.
We conclude that it is unwise to consider real estate investments as a hedge

against deflation. However, it is expected that equity financed real estate
investors with long term and well enforceable lease contracts will perform
better under a deflationary environment than highly leveraged investors
with uncertain tenant creditworthiness. Good investments for deflation are
accordingly based primarily on safety, which definitively left cash to be the
sole asset not to decline during deflationary periods. In addition, no single
segment of real estate investment – the residential, office, retail or the
industrial segment – seems to clearly offer any advantage over another,
while our preference would be the residential real estate market.
Thomas Veraguth, Analyst, UBS AG
Commodities - ambiguous impact

There is no simple answer to how deflation might impact commodities.
Deflation risks are a topic for the developed world but not for emerging
markets. It is the developed world that needs to deleverage. Emerging
markets still have room to increase leverage and reap the benefits of
their catch-up potential. Hence, the overall impact on commodities is
ambiguous. Commodities are real assets and, in an environment of no
genuine inflationary pressure, there is less need for prices to appreciate
in nominal terms. Moreover, deflationary environments are generally
accompanied by subdued economic activity. Economic textbooks suggest
that the impact of deflation on commodities would be negative, on
average. Economically sensitive commodities like base metals and energy
would suffer the most.
In reality the impact depends on the degree of deflation. On average,

more than 55% of commodity demand relates to emerging markets,
which we forecast to grow at a robust pace. Were the deflation in the
develop world mild, emerging market growth would be sufficient to see
commodity prices still trending higher in USD, EUR or JPY terms. With
the present market situation, we think commodity prices are more than
halfway through the process of discounting a very negative economic
outlook. Base metal prices, with the exception of copper, have been trading
below marginal production costs. In the case of crude oil, prices are at the
lower end, where investment will satisfy long-term demand. Thus, there
is limited downside potential from present levels in the case of increased
deflationary tendencies. Given the oligopolistic supply structure of crude
oil and the strong emerging market demand, crude oil prices should still
head towards USD 90 to USD 100 per barrel, but perhaps with a delay of a
year or two. Agricultural commodities would only be affected in a limited
way. Incremental here demand also relates to emerging markets. Gold
would hold up well initially, given the uncertainty that would likely prevail.
However, a strong appreciation in nominal terms would be difficult. That
said, in a later stage gold would come under pressure and drop below USD
1000/oz as the market would price gold again as an industrial commodity
and not as a currency to protect against inflation.
Dominic Schnider, Analyst, UBS AG
Appendix
Fig. 11: Fiscal debt monetization and inflation
Consumer Price Index in percentage points
15 Fiscal m onetisation during Volcker

Consum er price inflation (% yoy, 11 year m a) WWI clam ps
Fiscal m onetisation during down on
Napoleonic wars: deficit inflation
10 WWII
m onetised
US war of
US civil war
independence
0
Fiscal m onetisation during
Vietnam War; oil shocks
1st industrial revolution: 2nd industrial revolution:
(5) productivity- led deflation productivity rebound; gold finds
Depression
(10)
1750 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000
US UK
Source: Reuters EcoWin, UBS WMR, as of 25 Sept 09
Real Estate Appendix

The present capital value for return oriented residential and commercial real estate depend both on expected future cash flows - the
future net operative income (NOI) - in the numerator and on the required capitalization rate on the denominator. The appropriate
net operating income (NOI) is generally driven by expected economic or income growth (1), the expected tenant default's rates
(2), the expected duration of the lease contracts (3) and possible vacancies (4). Capital values are therefore positively driven by
improving expectations towards future NOI but also by falling capitalization rates. Capitalization rates on the other hand are made
up of at least three elements: the real interest rate (1), the expectations over future inflation (2) and a risk premium (2), which
rewards investors for risk taking. Therefore real estate capital values are fundamentally determined by inflation expectations not
actual inflation.
Appendix
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Deflation Ubs June 2010

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Philippe G. Müller, CIIA, analyst, philippe-g.mueller@ubs.

Wealth Management Research 11 June 2010

On the cusp Fig. 1: WMR inflation expectations

Although we think it is less likely to unfold than an inflationary environment

Source: UBS WMR, Reuters Ecowin, as of 07. June 2010

This report has been prepared by UBS AG.

Economics — Defining deflation

The cause of pernicious deflation is said to be a collapse of aggregate

We contend that, in the longer-term, inflationary pressure may be the

Dirk Faltin, Economist, UBS AG

Managing assets and liabilities in Fig. 2: Energy-driven swing in headline inflation

Usually, in a deflationary environment it is not only consumer goods and

Implications for investors are straightforward: If deflation is anticipated with

Daniel Kalt, Economist, UBS AG

inflation is expected to decline, yields tend to decline and prices for 10

nominal government bonds tend to rise. It is important to note that 8

impact the former as inflation expectations tend to be adaptive. Thus, the 2

developments of yields is not only correlated to inflation expectations, but 0

Nominal government bonds preferred

What if there were in fact a lengthy period of unexpected deflation,

Considering corporate credit

driving credit risk premiums higher. Companies with considerable amounts

Therefore, credit issuers that benefit from guarantees (supranationals,

The potentialy lower liquidty of corporate bonds is also an important aspect

Inflation-linked bonds can still shine during deflation

Dirk Effenberger, Analyst, UBS AG

Inverse floating rate notes and curve positioning 3.5

lower interest rates. In an ordinary interest-rate cycle, long-term interest 2.5

rates first fall in anticipation of lower inflation as investors accept lower 2

compensation. To limit deflationary pressures and ensure gradual price 1.5

It is crucial to distinguish between theory and practice when investing.

In anticipation of future deflation or substantially lower inflation, investors

Daniela Steinbrink-Mattei, Economist, UBS AG

Currencies — Deflation promises chaos

The economic inefficiency of reducing the growth prospects of a country

The currency cycle of deflation

■ The onset of deflation leads to a rapid reduction of credit positions

In short, deflation promises chaos on currency markets. In the first phase,

We identify two disruptive processes at work in this cycle. One kicks in at

The most likely candidate for a deflationary cycle is Japan, which is

Thomas Flury, Economist, UBS AG

Equities — Diversification is key Fig. 6: Pricing power sectors fare better in

to rise in a deflationary environment, bond yields tend to fall, making 100

even under these circumstances and to show slightly positive earnings

suffer in a deflationary environment. The auto sector meets both of -10%

costs, higher customer credit defaults in a deflation scenario would add

pressure to auto makers' balance sheets. Given the significant profit

in a deflationary environment, in our view. Other consumer discretionary

So far, we discussed the case of equity in closed economy and capital

To sum up, a deflationary environment would probably be challenging for

Philippe G. Müller, Analyst, UBS AG

Hedge Funds and Private Equity

Private Equity: If the deflationary phase is prolonged, we advocate staying

Cesare Valeggia, Analyst, UBS AG

Real estate Fig. 8: Capital growth and deflation

Deflation expectations materialized quickly in the fourth quarter of 2008

leveraged real estate investors may be forced by their lenders to increase

credit quality will be put into question. Furthermore in a severe deflationary

We conclude that it is unwise to consider real estate investments as a hedge

Thomas Veraguth, Analyst, UBS AG

Commodities - ambiguous impact

In reality the impact depends on the degree of deflation. On average,

Dominic Schnider, Analyst, UBS AG