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Key financial market driver 1 – Eurozone crisis

Key questions
• What do we expect from the economy and ECB policy?
• Can Spain and Italy continue to tap the primary market if they ask for a support program?
• How much more support will Greece receive and will it be able to stay in the Eurozone next year?

CIO View (Probability: 70%*)
Austerity and weak growth
• We think the Eurozone economy troughed in 3Q. We expect flattish growth in 4Q 2012 and 1Q 2013 (in line with consensus). Beyond this, uncertainties regarding the debt crisis and continuing fiscal austerity efforts will likely keep the pace of recovery subdued. The ECB is still in easing mode but after announcing a conditional bond purchasing program, it would take a marked worsening of the debt crisis and/or a worsening of economic data to trigger any further policy action.
• There is political pressure on Spain to apply for official financial support (OMT by the ECB and direct support from the EFSF/ESM). However, the government may hesitate until market pressure rises and/or clear political benefits are on offer. We think that Italy will have to apply for an aid package similar to Spain’s. We see a high probability of Spain being downgraded to junk by at least one rating agency.
• OMT bond purchases in the secondary market will focus on maturities of up to three years and countries will be expected to maintain their funding profiles by also issuing longer-dated bonds. Hence, longer yields should stay elevated as bondholders remain concerned about countries' ability and willingness to implement necessary reforms, and about the de-facto subordination to ECB holdings and official loans. The central banking supervision at the ECB is unlikely to be ready by January 2013, meaning that direct bank recapitalization through the ESM remains unavailable.
• We think Greece will not exit the euro in 2012 but will sign a new memorandum by November, although further delay is possible. We think that Greece's failure to meet targets may trigger a cut-off from funding by early 2013 and a possible gradual exit later. Portugal and Ireland should remain on track with their bailout packages, Cyprus will likely get a new package and Slovenia may ask for help soon.

Positive scenario (Probability: 15%*)
Return to macro stability
• Bond yields are contained as peripheral countries' budgets stay on track and economic activity recovers faster than expected. Greece complies with the new austerity plans and market confidence is restored.
Negative scenario (Probability: 15%*)
Major shock
• Major shocks include Spain and Italy being fully cut off from bond markets, i.e. requiring all new funding through EFSF/ESM/IMF loans, with European rescue funds only able to cover them until the end of 2013; resistance from core countries against the ECB program and further support; a Portuguese default; a Greek euro exit before the end of 2012; or a major external shock.

Key dates
TBD Troika report on Greece
8 Nov ECB press conference
12 Nov Eurogroup meeting
15 Nov Eurozone GDP 3Q: first estimate
22 Nov Eurozone composite purchasing managers index
22–23 Nov European Council

Purchasing managers indices point to ongoing contraction in 3Q
[Chart showing graph lines for Manufacturing, Services, Composite, No-change line from 07 to 12]
Source: Bloomberg, UBS, as of October 2012

Yield of Spanish and Italian 10-year bonds over German Bunds (in bps)
[Chart showing graph lines for Italy and Spain from 03/2011 to 09/2012]
Source: UBS, Bloomberg, as of 16 October 2012
Note: Past performance is not an indication of future returns.
* Scenario probabilities are based on qualitative assessment.

UBS
For further information please contact CIO analyst Thomas Wacker, thomas.wacker@ubs.com and CIO economist Ricardo Garcia, ricardo-za.garcia@ubs.com
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Please see important disclaimer and disclosures at the end of the document.
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