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Key financial market driver 2 - US economic outlook Key questions e Is the nascent growth recovery sustainable? Will the Fed stimulus boost growth? e How will the election result change fiscal policy deliberations? ® Can politicians find an agreement to avoid a sharp fiscal contraction in early 2013 (i.e. the "fiscal cliff")? CIO View (Probability: 70%*) Moderate expansion * The economy stays on a moderate growth path but the unemployment rate comes down only very gradually - the September report exaggerated the pace of improvement. Core personal consumption expenditure (PCE) inflation stays slightly below or close to the Federal Reserve's target of 2%. UBS forecasts real GDP growth of 2.0% in 3Q 2012 (consensus: 1.8%) and 1.6% in 4Q 2012 (consensus: 1.9%). The Fed has added considerable stimulus: it extended Operation Twist and its interest rate forward guidance, indicated that it will stay highly accommodative even after the recovery strengthens, launched an open-ended agency mortgage-backed securities (MBS) purchase program of USD 40bn per month, and shows a strong easing bias tied to the state of the labor market. The Fed actions effectively mitigate downside growth risks, but they are unlikely to dramatically boost growth. ¢ In the elections, Republicans will likely lose seats in the House on a net basis but retain a majority; we expect them to be even with Democrats in the Senate. Obama will likely retain the White House. Such an electoral outcome would prolong the existing gridlock between Republicans and Democrats. ¢ Due to the ongoing political gridlock, we expect modest fiscal tightening. The government will likely let unemployment benefits phase out and payroll tax cuts expire, but postpone income tax hikes and sequester spending cuts. Such a decision would lower the federal deficit by 0.7% of GDP, with a likely lower real GDP growth impact as households could buffer the income loss with lower savings. A Positive scenario (Probability: 10%*) Strong expansion ¢ Propelled by expansive monetary policy and a fading Eurozone crisis, growth accelerates persistently above 3.0%. This leads to higher inflation and the Fed responds by halting QE3 and raising rates sooner. * The better economic outlook raises the odds of an Obama reelection and makes it harder for Republicans to gain seats in Congress. Faster-rising tax collection and a Democratic stronghold leads to some tax hikes and limited spending cuts. Fiscal policy tightens by about 1.2% of GDP in 2013. & Negative scenario (Probability: 20%*) Growth recession ¢ US fiscal deleveraging and an escalating Eurozone crisis weigh on the cyclical recovery. Falling profit margins weigh on business capital expenditures. Real GDP growth deteriorates much further. The Fed massively purchases agency MBS and Treasuries under its QE3 program. ¢ The debt limit is reached earlier and the Treasury runs out of money before year-end. Political gridlock becomes dysfunctional, thus sending the country over the "fiscal cliff," with fiscal policy tightening by USD 607 billion (3.7% of UBS estimate of 2013 GDP) in 2013. The US credit rating is downgraded. Key dates 30 Oct Conference Board consumer confidence 1 Nov ISM manufacturing purchasing managers index for October 2 Nov Nonfarm payrolls and unemployment rate for October 6 Nov US presidential and Congressional elections 2 UBS US growth to pick up throughout 2013 US real GDP and its components, quarter-over-quarter annualized in % 8% UBS CIO qq annualized forecasts 6% ay 4% 2% 0% # 2% A% 6% 8% -10% 12% Q1 Q) Qt Qt Q1 Qt Qt Ql 2006 2007 2008 2009 2010 2011 2012 2013 mi Commercial real estate investment Residential investment Net Exports Real GDP (q/q annualized) li Consumption mi Capital expenditures ml Inventories Government Source: Thomsen Datastream, UBS, as of 15 October 2012 Budget impact of US fiscal cliff in 2013 Cumulative budget effects of fiscal cliff components, in % of UBS estimate of 2013 GDP 4.0 3.5 | 7 25 == 2.0 —=| 15 [| 1.0 0.5 0.0 ‘ + Ps) a by b : S Se ew oS we o sy ser Se 4 & i og ow gf & § OK RY eS ol s o 2d e .S gy is) < 3 ‘ oS rs of £ @ g 3 ar < fe a € a é Re) e - & ra & Ww & & oe ) Note: AMT = Alternative Minimum Tax, ACA = Affordable Care Act Source: CBO, UBS, as of 9 Octeber 2012 * Scenario probabilities are based on qualitative assessment. Note: Past performance is not an indication of future returns. For further information please contact US economist Thomas Berner, thomas.berner@ubs.com 2 Please see important disclaimer and disclosures at the end of the document. HOUSE_OVERSIGHT_025256