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CIO WM Research

11 December 2013

Global financial markets

Asia Outlook 2014: Reforms, restructuring, and eight issues to ponder
Asian economies are likely to gain speed in 2014, although the
growth rate of 6% would still be among the lowest in a decade outside of the global financial crisis. Some countries need to address domestic imbalances. We believe China has set a good example in this regard.
Min Lan Tan, APAC Regional Head, UBS AG Yonghao Pu, Regional CIO Asia-Pacific, UBS AG Kelvin Tay, Regional CIO, Southern APAC, UBS AG Hartmut Issel, analyst, UBS AG Patrick Ho, CFA, analyst, UBS AG

Table of Contents
Macro backdrop Market preferences Eight issues to ponder How should portfolios invest for yield? Will real estate prices correct? Will "SMAC" be a boon or a bane to Asian IT? Will consumer services offer better upside than consumer goods? What are the risk scenarios to key Asian currency trades? Where will the impact of deleveraging be felt in Asia? How will M&A and capex drive Asian markets? Could politics surprise in 2014? 1 2 3 4 4 5 6 7 8 9

Developed markets will likely continue to lead equity returns in

2014. This said, Asian valuations are undemanding, and we enter the new year with a preference for China. South Korea is also likely to outperform as exports play a more positive role in 2014.

As the Fed starts to taper its bond-buying program, the Korean won
and Singapore dollar will likely prove resilient to capital outflows, while the Indian rupee and Indonesian rupiah will likely be at risk. We like the Chinese yuan for its stability.

After years of solid returns, property markets across Asia, except

Japan, will likely face headwinds from deleveraging, cooling measures, and new supply. In contrast, the IT and consumer sectors will likely be driven by emerging positive trends. Yield-seeking investors should avoid taking excessive interest-rate risks.

Overall, 2014 promises to be an eventful year for Asian financial

markets, offering decent returns to investors. Global outlook improving. 2014 will likely be the first in four years that annual global GDP growth will accelerate, driven almost entirely by the advanced economies. Given benign inflation and fair valuations, we continue to expect risk assets, especially equities and high-yield credit, to outperform fixed-income assets such as high-grade bonds which we deem expensive. Macro challenges remain. A more broad-based global recovery should serve as a tailwind especially for the more export-oriented economies of North Asia and Singapore. Still, domestic restructuring pressures, along with tighter credit conditions, will likely compromise short-term growth. Our forecast GDP growth of 6% for Asia ex-Japan in 2014 though a rebound from 5.6% in 2013 would still be among the lowest in a decade if we exclude the years that encompass the global financial crisis (see Fig. 1). Moreover, even after two years of sub-trend growth, parts of Asia still exhibit classic signs of late-cycle imbalances, such as deteriorating current accounts, wage inflation, asset-price bubbles, and excessive lending.

Fig. 1: Asia ex-Japan real GDP (% year-on-year) Real GDP growth forecast for 2014 still one of the lowest in a decade ex-global financial crisis


0 2001 2002 2003 2004 2005 2006 2007 2008 2009

2010 2011 2012 2013 2014E

Source: UBS estimates, as of 29 November 2013

This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 10. Past performance is no indication of future performance. The market prices provided are closing prices on the respective principal stock exchange. This applies to all performance charts and tables in this publication.

Global financial markets

Meanwhile, as the Federal Reserve begins to taper its asset-purchase program in 2014, some Asian capital markets will likely be vulnerable to a repatriation of yield-seeking capital. These include India and Indonesia, which are suffering from current-account and trade deficits and where valuations are pricing in some positive outcomes from upcoming elections, as well as the smaller Southeast Asian markets. That said, we expect any potential rout to be less severe than the sell-off we saw in May, as we believe investors have at least partially priced in the Fed tapering. The 10year US Treasury yield is now at 2.8% compared with 1.6% in May, while the average AxJ long bond yield is now at 4.1%, up from 3.2%. Valuations are undemanding. Asia ex-Japan's GDP is now 85% above its level at the end of 2007, while the MSCI AxJ index remains 20% below its 2007 peak. Valuations have de-rated, due in part to lackluster corporate profits. The benchmark's forward price-to-earnings (P/E) ratio is now 11.2x (see Fig. 2) and price-to-book (P/B) is at 1.4x, down 37% and 48% from their 2007 peaks, respectively. Having underperformed MSCI World for the last three years, MSCI AxJ is now trading some 8% below its P/E average and 10% below its P/B average for the last five years. However, although Asia's GDP growth has been decent, corporate profitability has been weak due to shrinking margins. This year, the region's estimated return on equity (ROE) is only 12%, barely higher than the cyclical low of 11.9% in 2009 and below the past 10-year average of 13.5% (see Fig. 3). Still, the news is not all bad. For one, the Third Plenum reforms in China could have a profound impact in the medium term, as they could significantly diminish tail risks associated with an unsustainable economic growth model. Market preferences. Over the next six months, our Most Preferred equity markets in Asia ex-Japan are China and South Korea, while our Least Preferred markets are India and Indonesia. We have Neutral ratings on Singapore, Hong Kong, Taiwan, Thailand, Malaysia, and the Philippines. We think China's final reform blueprint will be a positive re-rating catalyst for the market, which now trades at a 21% discount to AxJ on a 12-monthforward P/E basis, deeper than the past five-year average discount of 11%. On currencies, we like those of economies that are export-sensitive and have low reliance on capital inflows, namely the Singapore dollar (SGD) and Korean won (KRW). We stay cautious on currencies of markets that are more domestically oriented and reliant on capital inflows, such as the Indian rupee (INR) and Indonesian rupiah (IDR). We also maintain a preference for the Chinese yuan (CNY) over the Taiwan dollar (TWD) due to yield differentials. Both units are the least volatile among Asian currencies and are relatively stable during episodes of risk aversion.

Fig. 2: Undemanding Asia ex-Japan valuations Current 12-month-forward P/E vs. historical average
18x 16x 14x 12x 10x 8x 6x 2006 2007 2008 2009 2010 201 2012 2013 Asia ex-Japan: 12-m forward PE
Source: Factset, UBS, as of 6 December 2013

Current: 11.2x 5 year average: 12.1x

5 year average

Fig. 3: Erosion in Asia ex-Japan return on equity UBS universe, excluding financials
20% 19% 18% 17% 16% 15% 14% 13% 12% 11% 10% 9% 8%














Source: UBS estimates, as of 29 November 2013

UBS CIO WM Research 11 December 2013


Global financial markets

Eight issues to ponder in 2014

Beyond the global and Asian macroeconomic backdrop, we see eight issues that we believe investors in Asia should carefully consider in 2014. 1. How should portfolios invest for yield? Wen Ching Lee, Carl Berrisford, Lili Fan Since the Fed introduced quantitative easing (QE) in late 2008, high-yielding stocks and bonds have done particularly well. The MSCI AxJ high-dividend-yield index has returned some 150% in US dollar terms, outperforming the broader MSCI AxJ benchmark by 32% (see Fig. 4), while the JPMorgan Asia high-yield bond index has returned 105%, beating the global investment-grade index by 50% (see Fig. 5). In 2014, equity yield plays could be undermined as the global recovery may lead cyclical stocks to outperform defensive ones (implying an opportunity cost for those investing purely for yield), while bond yield plays could suffer from higher US benchmark rates. Our forecast is for the 10-year US Treasury yield to rise 50 basis points (bps) to 3.3% by end-2014 from 2.8% currently. Still, investors' desire for yield remains, so how should they invest in 2014? In equities, we advocate a selective approach in favor of growth and income that is, stocks with good earnings-growth and dividend track records, and thus provide both capital-appreciation potential and income stability. This approach requires careful stock-picking across sectors. In emerging Southeast Asia, telecom stocks offer both profit growth and dividend yield (4.9%), while in the more mature Asian markets, they offer mostly dividend yield (5.7%). In Taiwan, select IT stocks are cyclically sensitive and have a history of paying out dividends for tax reasons; dividends of large-cap stocks typically yield 3.5%. In Hong Kong and Singapore, select conglomerates, banks, gaming operators, and capital-goods companies offer growth and income potential as the economic cycle improves. We expect these stocks to generate dividend yield above 3%. While banks could see wider net interest margins as interest rates rise, we would be cautious of select Chinese banks as their above 5% dividend yields are high for a reason. We recommend investing in only the largest of these banks. Asia also offers structural growth opportunities through monopolistic players or industry leaders that generate strong cash flows and earnings growth. Cases like this can be found in select Macau gaming, banking, and materials stocks, which offer average dividend yields of 4.3%, 4.4%, and 4.7%, respectively. Among real estate investment trusts (REITs), we prefer the Japanese REITs especially in the office sector, where the ongoing early-stage recovery could underpin a potential dividend yield of 3.5% and capital appreciation of 5 10% in 2014. Select high-yield REITs in Hong Kong and Singapore may enjoy some rental growth; however, their cash flows are largely generated from mature properties, and their valuations are more likely to be driven by yield spread rather than earnings growth. While J-REITs' yield spread of 2.8% may stay flat due to the Bank of Japan's QE program, AxJ REITs' yield spread of 3.4% could slide back to the seven-year average of 2.9% as domestic rates rise with the Fed tapering. In fixed income, we advise against taking excessive interest-rate risks. We prefer bonds with medium-term maturity of about five years in the investment-grade segment, and recommend investors with high risk tolerance to selectively look into high-yield bonds to generate yield. Currently, Asian investment-grade and high-yield bonds provide credit spreads of 220bps and 510bps over US Treasuries, respectively. In the next six

Fig. 4: MSCI AxJ high-yield index has outperformed MSCI AxJ by 32% since start of QE Standardized to 100 in end-2008
350 300 250 200 150 100 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13

MSCI AxJ high dividend yield index TR

Source: Bloomberg, UBS as of 6 December 2013

MSCI AxJ index TR

Fig. 5: Asian high-yield bonds have outperformed global investment-grade index by 50% since start of QE Standardized to 100 in end-2008
230 210 190 170 150 130 110 90 31-Dec-08 31-Dec-09 31-Dec-10 31-Dec-11 31-Dec-12 Global IG bond index JPMorgan Asia High Yield bond index

Source: Bloomberg, UBS as of 6 December 2013

UBS CIO WM Research 11 December 2013

Global financial markets




50,000 40,000




16,300 13,100 6,700

10,000 0

Since 2009, prices of centrally located condominiums have risen markedly across major Asian cities: up 129% in Hong Kong, 121% in Shanghai, 85% in Jakarta, 56% in Singapore, 38% in Manila, 32% in Bangkok, and 25% in Kuala Lumpur. Tokyo is a key exception, with prices remaining flat over the same period. Given the region's ample liquidity, favorable demographics, and strong job markets, significant price corrections are unlikely in our view. That said, we expect the property sector to face headwinds in 2014. Market-cooling measures such as lower loan-to-value ratios and punitive stamp duties remain in place, while the supply of new flats in markets like Singapore, Hong Kong, and China is set to soar in the next 2 3 years. Meanwhile, mortgage rates are normalizing and have started to rise in Indonesia, Hong Kong, and China. In 2014, we expect residential prices to fall 510% in Hong Kong and 3 6% in Singapore. In Hong Kong, the number of units available for sale in the next 34 years will likely reach 72,000, or 6.4% of the existing stock. Average home prices are now equivalent to 14.7 years of the average household income, slightly above the previous peak in 1997, while the debt-service ratio is starting to seem stretched at 65%. In Singapore, 167,100 new units, or 14% of the existing stock, are expected to enter the market from 20142016, the highest level in over two decades (see Fig. 6). In China, the pace of home-price increases could slow down from about 10% in 2013 to 510% in 2014, as supply in first-tier cities improves and monetary conditions tighten. In Taiwan, rental yield has fallen to a record low of 1.57%, signaling a potential decline in investment demand. In Malaysia and Indonesia, policy is a key headwind. Malaysia recently raised the property gains tax and doubled the minimum price of properties foreigners can buy. In Indonesia, mortgage rates as well as minimum downpayments for second and subsequent home purchases have increased. In Thailand, political uncertainty may curtail investment demand, but primary home prices could still rise due to higher land and construction costs. On a brighter note, Japan's office market is in an early-stage recovery; we expect vacancy rates to fall to 6.2% by end-2014 from 7.56% as of endOctober this year (see Fig. 8), and rents to rise starting mid-2014. Home purchases in 2014 will likely be front-loaded to avoid the value-added-tax hike starting April, and slow down thereafter. 3. Will "SMAC" be a boon or a bane to Asian IT? Sundeep Gantori, Glenda Yu We think the ongoing disruption in the global technology sector centered around social, mobility, analytics, and cloud technologies (SMAC) has far-reaching implications on Asian investments given the region's role as a hub for IT manufacturing and services.

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014E 2016E Public Private

Source: HDB, URA, MND, UBS, as of 29 November 2013

Fig. 7: Hong Kong house prices have nearly quadrupled from 2003 trough Hong Kong houses prices, rebased





0 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: Hong Kong Government, CEIC, UBS as of 9 December 2013

Fig. 8: Tokyo metropolitan area office vacancy rate in %

10 9 8 7 6 5 4 3 2 1 0










2. Will real estate prices correct? Patrick Ho, Wen Ching Lee, Glenda Yu, Toru Ibayashi, Lili Fan, Cheryl Chian, Nicholas Yeo

17,000 15,800

30,000 20,000

9,500 13,500








20,200 30,400





months, we expect about 1.8% total returns from investment-grade bonds and about 3.2% from high-yield bonds in Asia, versus a 1% return from global high-grade or government bonds. Pure yield-seeking investors could also take a multi-asset approach. In 2014, we expect Asian high-yield and investment-grade bonds to generate yield of about 7.5% and 4.5%, respectively, while REITs and dividend-paying stocks are now trading at yields of 4.1% and 2.7%.

Fig. 6: Singapore to see record high supply of residential units in 20142016 167,100 new units expected in next two years, the highest in over 20 years



Source: Miki Shoji, as of 20 November 2013

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Global financial markets

In social media, we see strong growth prospects for Asia, particularly in China, India, and Indonesia three of the world's most populous countries. Internet penetration in these markets is still low at 42.3%, 12.6%, and 15.4%, respectively, compared with 84% in Japan, 81% in the US, and 79% in South Korea (see Fig. 9). In our view, China's internet industry represents the most interesting investment opportunity given its advanced stage of monetization, large user base, rapid growth in online financial transactions, and strong online-gaming culture. However, some internet stocks already have lofty valuations, in our view, and we prefer the large, diversified internet portals with proven business models. Year-todate, China's small- to mid-cap internet stocks have returned 118% and are trading at 44x 2014 P/E, whereas the large-caps have returned 64% and are trading at only 27x P/E. Mobility is potentially the most disruptive force for the Asian IT sector. In 2014, we expect Asia's consumption of low-cost smartphones and tablet PCs to grow rapidly thanks to the wider rollout of 4G/LTE networks. For Asian IT manufacturers, the outlook is less sanguine as the overall annual growth rate for the smart-device market is expected to decelerate to 20 30% from 50% currently, while the PC market remains under pressure from the rising adoption of tablet PCs. One potential catalyst for Asian IT manufacturers is Apple's expected introduction of large-screen iPhones, iPads, and new products such as wearable devices and television, which we believe would mostly benefit Taiwan's IT supply chain. In our view, concerns about a large-scale "re-shoring" of IT manufacturing back to the US are overblown. While wages in Asia are rising, the region remains a highly competitive base for IT manufacturing given its established clusters of component suppliers and vast pool of research and development talent. The growing use of data analytics and cloud computing will have a slightly positive impact on Indian offshore IT service vendors, in our view. As companies increasingly integrate enterprise applications, we see a nearterm boost in related spending. That said, a faster-than-expected adoption of cloud applications, which increase automation, could be a long-term threat to future IT spending. Asian hardware suppliers to cloud vendors in the power-solutions and server segments stand to benefit.

Fig. 9: Internet penetration in India, Indonesia and China Still low compared to Japan, South Korea and the US
90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% India Indonesia China Japan Korea US 12.6% 15.4% 42.3% 79.1% 84.1% 81.0%

Source: World Bank, UBS, as of 29 November 2013

Fig. 10: Consumer services grow faster when Asia's emerging markets urbanize Correlation of urbanization and marginal propensity to consume, by sector
1 0.8 0.6 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8 -1



Leisure & recreatn


Phase 1

Phase 2

Note: Phase 1 refers to GDP per capita above USD 1,500, Phase 2 to GDP per capita above USD 2,500 Source: UBS, as of 23 October 2013

4. Will consumer services offer better upside than consumer goods? Carl Berrisford Since 2007, Asia's consumer-goods sector has outperformed the consumer-services sector by around 53%. For 2014, we see a strong case for switching out of expensive consumer-goods stocks in favor of consumer-services stocks such as select Macau gaming operators, Chinese IT services and drug makers, Southeast Asian medical-tourism providers, and regional airlines. Asia's consumer-goods industry is grappling with overcapacity issues, intense rivalry, slowing top-line growth, and margin pressure. In China, the food-and-beverage, retail, and discretionary-goods markets are so fragmented that industry leaders enjoy only single-digit market shares. The valuations of consumer-discretionary stocks also tend to be unattractive: some Chinese blue-chip names with doubledigit earnings growth are trading in the high-20s multiple, while Southeast Asian and Indian names are trading beyond 30x. We therefore prefer select consumer-services stocks for a number of reasons. First, we see better long-term growth potential in sectors like healthcare, leisure, transport, and IT services thanks to policy support. From India to China, Asian governments are promoting the service sectors to reduce their dependence on manufacturing. Second, licensing restrictions
UBS CIO WM Research 11 December 2013 5


Health & medical


Alcohol & tob


Clothing & footwear

Household goods

Global financial markets

in sectors such as gaming, telecom, and healthcare raise entry barriers and help rationalize capacity expansion. In Macau gaming, for example, the listed players form an oligopoly. Third, we have found that urbanization in emerging markets translates into stronger consumption of services rather than goods (see Fig. 10). As these markets reach per capita GDP of USD 2,500, more disposable income is spent on education, healthcare, leisure, transport, and communication. Fourth, unlike consumer-goods leaders, the top players in sectors such as healthcare and gaming have double-digit growth prospects, and their valuations are in the low-20s multiple. Finally, the average ROE of consumer-services stocks is at least 5% higher than that of the MSCI consumer-goods sector, while their average dividend yield is 200bps higher.

5. What are the risk scenarios to key Asian currency trades? Teck Leng Tan, Gary Tsang We expect the Fed to commence QE tapering in March 2014. As this would lend strength to the US dollar, we forecast a weakening of the Australian dollar and the Japanese yen, and a modest appreciation of the Chinese yuan. Our 3-, 6-, and 12-month estimates are as follows: AUDUSD 0.90, 0.88, 0.85; USDJPY 102, 105, 105; and USDCNY 6.05, 6.00, 5.95. AUDUSD. The risk of a surprise AUD appreciation is remote in our view. Reserve Bank of Australia (RBA) Governor Glenn Stevens has said in October that the AUDUSD will be "materially lower" in the future, and we couldn't agree more (see Fig. 11). First, as China shifts toward a less-commodity-intensive growth model, foreign investment in Australian mining is likely to decline. Second, as AUDUSD yield differentials narrow with the Fed tapering, we expect less inflows into the Australian government bond market. Combining both factors, we believe Australia's sizeable currentaccount deficit of around 3% of GDP could start to exert downward pressure on the AUD. As well, the RBA's explicit preference for a weaker AUD to attract investment in the non-mining sectors gives the AUD an unattractive profile. In short, we believe the AUDUSD is overvalued and could trend lower to 0.85 in the next 6 to 12 months. The risks to this base case are a postponement of the Fed tapering, which would renew investor demand for high-yielding currencies such as the AUD, and a strong domestic recovery in Australia, which would shift the RBA's policy bias from dovish to hawkish. USDJPY. The yen has been the market's favorite funding currency since the Bank of Japan (BoJ) embarked on an unprecedented easing program in April to combat deflation. Even after weakening by more than 25% against the USD since late 2012, the JPY faces little risk of a strong rebound in our view. First, the BoJ is likely to remain as the most accommodative G10 central bank, as it is still far from achieving its core CPI target of 2% by April 2015. In fact, our economists believe the BoJ must step up its QE program by 2Q14 or it will fall short of its inflation target. Second, the Fed tapering vis--vis the BoJ's loose policy will widen the differential between US Treasury and Japanese government bond yields over the next year (see Fig. 12). Third, trade flows continue to weigh on the yen, as Japan's trade balance is likely to remain negative given the country's need to import fuel to make up for its loss of nuclear power. Thus, we expect the USDJPY to trade within a higher range of 100110 in the year ahead. The risks to this base case are a postponement of the Fed tapering and a renewed downturn in global growth, leading to "safe haven" demand for the JPY. USDCNY. Since China introduced exchange-rate reforms in 2005, the yuan has not experienced a period of sustained depreciation. This trend is unlikely

Fig. 11: AUDUSD overvalued by around 20% Fair value of AUDUSD should be around 0.76, according to our PPP calculations
1.15 1.05 0.95 0.85 0.75 0.65 0.55 0.45 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 AUDUSD PPP AUDUSD

Source: Thomson Reuters, UBS, as of 28 November 2013

Fig. 12: USDJPY relative to interest yield differentials Widening USJapan yield gap should support higher USDJPY
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 140 130 120 110 100 90 80 70 Dec-13

UST-JGB 10 year yield differentials (%, LHS)


Source: Bloomberg, UBS, as of 5 December 2013

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Global financial markets

to change even though China's deleveraging could result in lower trend growth. In the past, even during the global financial crisis, the CNY has moved in line with the USD. While it depreciated by about 1% from 2Q12 3Q12, this period was exceptional as the market had been plagued with fear of a Chinese economic hard-landing; indeed, GDP growth fell to a low of 7.4% in 3Q12. For 2014, we forecast China's GDP to rise 7.8%, from 7.6% in 2013. We expect the Fed tapering to have a limited impact on the CNY given China's current-account surplus (estimated at 2% of GDP in 2014), strong foreign reserves (about 40% of GDP), and a largely closed capital account. Furthermore, international political pressure will put a cap on CNY depreciation. We expect a modest CNY appreciation to 5.95 against the USD in the next 12 months, with the daily trading band widening to +/-2% from the current 1% in 2014. The risk to this base case is a hard landing due to policy missteps or a significant slump in external demand. 6. Where will the impact of deleveraging be felt in Asia? Lili Fan, Glenda Yu, Hartmut Issel, Wen Ching Lee On average, Asian countries' overall-debt-to-GDP ratio has risen from 151% in 2008 to 181% today (see Fig. 13). This has been facilitated by loose global liquidity conditions and rapid domestic credit creation to bolster demand amid faltering exports. Going forward, we expect the Asian credit cycle to start to unwind, both as domestic banking systems close in on their loan-to-deposit ratio limits, and as the Fed tapering causes international capital to become more selective about where to invest. While deleveraging will likely constrain China's near-term GDP growth, the impact on Chinese equities may in fact be positive. Many of China's structural problems such as industry overcapacity and the crowding-out of the private sector are partly a result of banks systematically misallocating credit. The Third Plenum reforms set China on a path to gradual deleveraging. While this may reduce the pace of credit growth, policy support for better credit allocation toward the private sector, small and mediumsized enterprises, and the service sector will improve credit efficiency in our view. Promoting market-based pricing of resources should discourage over-borrowing which in the past had resulted in unprofitable investments. In short, for Chinese equities, we think deleveraging will result in valuation re-ratings as medium-term financial risks are lowered. For Chinese bonds, deleveraging may lead to a near-term increase in distress and default cases in the high-yield segment. State-owned enterprises (SOEs), which are mostly investment-grade, may gradually lose funding advantage. As domestic funding becomes more expensive, SOEs may seek cheaper funding overseas, thereby lifting the supply of bonds. That said, over the longer term, we could see more issuance from private enterprises in China, which would then offer interesting opportunities for foreign fixed-income investors. In Southeast Asia, the Fed tapering may turn foreign inflows into outflows. Since end-2008, India, Indonesia, and Thailand have attracted a combined USD 90bn in net foreign inflows into their local government bond markets. At the same time, Asian bank loan growth has outpaced GDP growth. In Indonesia, Thailand, and India, this has weakened current account positions, and suggests that credit growth now needs to moderate. We think Asia's deleveraging and the potential repatriation of yield-seeking capital validate our equity underweight position in South Asia relative to North Asia.

Fig. 13: Higher Asia ex-Japan debt levels Weighted average overall-debt-to-GDP ratio, in %
210 200 190 180 170 160 150 140 130 2008 2009 2010 2011 2012

Note: Overall debt = household debt + non-financial corporate debt + government debt Source: UBS, CEIC, Haver, Morgan Stanley Research as of 2 December 2013

Fig. 14: Loan growth by financial institutions has outpaced GDP growth in Southeast Asia Excess loan growth over nominal GDP growth, 20102012, annualised
12% 10% 8% 6% 4% 2% 0% ID PH TH IN MY TW CN KR
Source: CEIC, UBS as of 29 November 2013

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As well, household deleveraging could be a headwind to property prices in markets such as Singapore and Hong Kong. To be sure, the rise in household debt in Singapore does not pose a systemic risk as it has been accompanied by even stronger growth in savings and assets. Still, tight government regulations and gradually normalizing interest rates could spur a household deleveraging cycle in 2014. That said, a sharp rise in loan defaults is highly unlikely as over 70% of mortgages are for owner-occupied homes, and the average loan-to-value ratio remains fairly conservative at 47.5%. A tight labor market is also supportive of household incomes. In Hong Kong, we expect household balance-sheets to remain solid for similar reasons. Since the government has tightened mortgage lending standards amid rising demand for loans, Hong Kong banks may raise their lending spreads. Given that the vast majority of mortgages are based on floating interest rates, any increase in mortgage rates will put pressure on households' debt-service costs.

Fig. 15: Investment in intangibles is the main driver of Hong Kong economy Contribution to nominal GDP by industry in 2012

Primary industries 0.1%

Manufacturing 6.9%

7. How will M&A and capex drive Asian markets? Patrick Ho, Sundeep Gantori While we forecast some acceleration in most Asian economies, aggregate growth remains below trend. On one hand, deleveraging in China, liquidity pressure in Southeast Asia, stronger currencies, and lower commodity prices have constrained demand. On the other hand, an aging population, rising wage costs, infrastructure bottlenecks, and weak institutions present a drag on supply. The demand headwinds mean an ill-conceived investment in new capacity could easily compress profit margins. That said, we think Asia needs new investments that boost productivity, lower production costs, and enhance competitiveness. We expect Southeast Asia to continue to invest heavily in infrastructure and natural resources. The Philippines and Malaysia, in particular, are in a good position to do so as they face lesser financing, overcapacity, and institutional constraints. Hong Kong is a different story as the service sector accounts for over 90% of the economy (see Fig. 15). Its strong rule of law, efficient capital markets, and competitive business environment also attract talent that helps enhance productivity. In the banking sector, the spotlight has turned to consolidation as a way to boost productivity and lower unit costs. We like the mid-cap Hong Kong banks for their potential acquisition premium. In Japan, private and public capital expenditure has declined for the last 20 years as deflation took hold and companies shifted production overseas. The Abe administration now aims to reverse this trend, which supports our theme "Third arrow of Abenomics: Japan's capex revival." The theme highlights equity investment opportunities in the capital-goods, construction, enterprise-software, property, and financial sectors. In China, marginal returns on investment have fallen markedly since the 2008 credit boom due to the "questionable" quality of the overall capital accumulated during this period. That said, China still needs investments in industrial sectors, including IT and telecommunications, given its low capital stock per capita relative to developed economies and need for more advanced technologies. We expect mergers and acquisitions to remain active in the internet and dairy sectors. The dominance of state enterprises in most Chinese industries has been a drag on productivity and margins. In our view, M&A will help transform and improve the competitiveness and productivity of the state-owned sector. We expect some large but unproductive de facto monopolies, such as companies in the telecom sector, to suffer.

Services 93.0%
Source: CEIC, UBS, as of 9 December 2013

Fig. 16: Survey shows Japan corporate capex to increase 13.1% for year ending March 2014 Planned capex increase in select industries, in % year-on-year
Chem ical Steel Metal Glass Electronics Auto Machinery Oil Rubber Pharm aceutical Railway/ Bus Retail Property Construction Airline Finance 11.4% - 13.6% 9.8% 21.3% 5.4% 16.5% 4.1% 18.5% 32.5% 3.3% 17.1% 17.2% 46.9% 32.9% 17.9% 19.6%

Source: Nikkei Shimbun, UBS as of 2 December 2013

UBS CIO WM Research 11 December 2013

Global financial markets

8. Could politics surprise in 2014? Hartmut Issel, Glenda Yu, Lili Fan, Carl Berrisford In China, the Third Plenum has shed light on the long-running reform puzzle. That said, we think the market has yet to fully appreciate the central government's measures to rein in local governments' power, whether by taking on more fiscal responsibility, reforming the judiciary, streamlining project approvals, or making market forces a more "decisive" factor in resource allocation. To us, these changes are more important than the list of reforms the equity market is excited about, as they will improve China's economic efficiency and political transparency. We believe policies with a strong consensus within the Communist Party, including fiscal, tax, and one-child policy relaxation, will proceed meaningfully. Other policies such as financial, SOE, "hukou," and land reform will likely be rolled out gradually. The campaign against corruption will likely continue, though we think it will target personnel rather than the company level, as recent cases against selected SOEs have demonstrated. India and Indonesia will hold general elections in 2014, with structural economic policies on the line. For India, comprehensive reforms are critical, but there are low-hanging fruits that could be implemented without new legislation. One example is the approval of various pending industrial projects. Recent polls suggest the NDA opposition coalition led by the BJP party could take over the reins in May. With the stock market near all-time highs, valuations may already be pricing in Gujarat's market-oriented minister Narendra Modi taking the Prime Minister seat. Elections in India are naturally hard to call. If the NDA fails to accumulate enough votes, it may end up in a weak position relative to other outside support parties that may not back Modi. In our view, a Modi-less government will surprise investors and douse hopes for swift reforms. In Indonesia, the most popular contender for the presidential post, according to polls, has yet to be nominated by any party. Jakarta's governor Joko Widodo is known for championing public infrastructure investments and has a reputation for clean politics. We think the PDI-P party is increasingly likely to nominate him as its standard-bearer. Since the party also wants to command as many votes as possible and is looking to have bargaining power over potential coalition partners, Widodo's nomination could be made official in early 2014. While the issues facing Indonesia will be hard to resolve for any incoming president, we think infrastructure construction companies are almost certain to see a revival of fortunes should Widodo be elected. Amid a slowing economy, Thailand's opposition Democrat Party has reignited a deep-seated conflict between the party and the Shinawatra dynasty. This has culminated with the year-end dissolution of the Thai parliament and Prime Minister Yingluck Shinawatra calling a snap election by mid-February. Opposition leader Suthep Thaugsuban's political agenda is vague but seeks to replace Thailand's constitution and democratic institutions. It remains unclear whether his party would be prepared to accept another defeat at the polls at the hand of Shinawatra. The key casualty from this political deadlock is the Thai economy, which has suffered a sharp growth slowdown in 2H13. There is an increasingly high likelihood that the execution of the THB 2 trillion infrastructure plan will be delayed due to political obstacles, challenging Thailand's 2014 growth outlook, in our view.

UBS CIO WM Research 11 December 2013

Global financial markets

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UBS CIO WM Research 11 December 2013