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UK equities
Preference: neutral

UBS View
FTSE 100 (24 Oct): 5,805 (last publication: 5,768)
FTSE 100 (6-month target): 5,850

• We keep our neutral stance on UK equities. Earnings have continued to disappoint, showing one of the weakest dynamics within our market universe. Commodity related sectors show steep earnings declines, which is expected to moderate only in a lagged fashion to stabilizing commodity prices. The Healthcare sector suffers from company specific issues which affect earnings also negatively.
• With the oil price expected to trade down over the next 3 months, earnings of companies in the energy sector - comprising about 20% of the market – should remain depressed over the coming quarters. Within financials, law suits related to mis-selling of insurance related products represent a special risk factor.
• Recent strengthening of the British pound is also a headwind for the competitiveness of UK companies, as earnings measured in the local currency are negatively affected.
• The PE of UK equities looks attractive at first sight. But over the past 10 years, UK equities traded on average at a discount to global equities.

Positive scenario
FTSE 100 (6-month target): 7,000
• A fast strengthening in global growth and recovering demand from emerging markets leads to fast rising commodity prices, helping the Energy and Materials sectors to lead the market higher. The market could re-rate to a P/E multiple of 13.0x, and we would expect earnings growth of 5–10% over 12 months.

Negative scenario
FTSE 100 (6-month target): 4,750
• A global recession drags UK earnings down by 15–20% over 12 months. The market's traditionally defensive characteristics would only partly offset its strong exposure to commodity-related sectors. We would expect the trailing P/E multiple to drop towards 10x.

Note: Scenarios refer to global economic scenarios (see slide 7)

What we're watching
Why it matters

Growth indicators
Business survey indicators provide information on economic development in the UK. Key date: 1 Nov, PMI manufacturing; 5 Nov, PMI services

Commodity prices
Energy and Materials together comprise about 30% of the UK market according to market capitalization. Developments in commodity prices affect earnings estimates.

Policy action
Loose monetary policy by the Bank of England supports equities. Key date: 8 Nov, Bank of England policy meeting

Recommendations
Tactical (6 months)
• The UK offers an attractive 4% dividend yield. We still like companies with high quality income streams.
• We like Consumer Staples in the UK. The sector should provide steady earnings growth through its exposure to emerging markets.

Strategic (1 to 2 years)
• The UK market's close to 4% dividend yield provides a good income stream.
• Companies with pricing power are expected to deliver superior earnings growth.

UK market trades at a P/E discount, based on realized earnings
[Chart showing FTSE 100: realized P/E vs MSCI World: realized P/E from 2003 to 2012]

Source: Thomson Reuters, UBS, as of October 24, 2012
Note: Past performance is not an indication of future returns.

UBS
For further information please contact CIO asset class specialist Markus Irngartinger, markus.irngartinger@ubs.com
Please see important disclaimer and disclosures at the end of the document.
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