M O R G A N S T A N L E Y R E S E A R C H
Global Cross-Asset Strategy Group
Morgan Stanley & Co. Inc.
Gregory Peters
greg....
M O R G A N S T A N L E Y R E S E A R C H
Global Debates Playbook
November 16, 2010
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Table of Contents Global Cross-Asset...
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Shifting to Neutral as Increased Dow...
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If, or When, Ireland Goes to the EFS...
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Inflation Risk in Emerging Markets a...
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Our Asset Class Views Reflect the Mo...
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Global Cross-Asset Strategy – Overvi...
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Investor Debates
Risk on or off?  W...
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Investor Debates by Asset Class
Rate...
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Asset Classes Base Case Views
Greg ...
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Asset Classes Base Case Views
Greg ...
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Asset Classes Base Case Views
Greg ...
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Risk-Reward Views
Greg Peters, (212...
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Global Economics Risk-Reward View
I...
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US Economics Risk-Reward View
Inves...
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Europe Economics Risk-Reward View
I...
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Japan Economics Risk-Reward View
In...
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China Economics Risk-Reward View
In...
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AxJ Economics Risk-Reward View
Inve...
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Brazil / Latam Economics Risk-Rewar...
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India Economics Risk-Reward View
In...
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Russia Economics Risk-Reward View
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US Rates Risk-Reward View
Investor ...
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Europe Rates Risk-Reward View
Inves...
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UK Rates Risk-Reward View
Investor ...
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EM Fixed Income Risk-Reward View
In...
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FX Risk-Reward View
Investor Debate...
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DM Equities Risk-Reward View
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European Equities Risk-Reward View
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Japan Equities Risk-Reward View
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Asia / GEM Equities Risk-Reward Vie...
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China (and Hong Kong) Equities Risk...
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Global Corporate Credit Risk-Reward...
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1
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November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1

  1. 1. M O R G A N S T A N L E Y R E S E A R C H Global Cross-Asset Strategy Group Morgan Stanley & Co. Inc. Gregory Peters greg.peters@morganstanley.com +1 212 761-1488 Jason Draho jason.draho@morganstanley.com +1 212 761-7893 Please see page 2 for full list of members Subscribe to the Global Debates Playbook, the latest investor debates and high- conviction trades from Morgan Stanley’s Global Cross-Asset Strategy Group We move from full ‘risk-on’ to a more balanced risk on / off view. All three of our market pillars — US growth, Europe sovereign risk, and the China ‘Goldilocks’ scenario — were flashing green for risk- on a few weeks ago. The constructive view was driven by the mantra “don’t fight the Fed.” That hasn’t changed for the US. But the high likelihood that Ireland will go to the EFSF fund and the contagion risk that this poses for the euro periphery is a risk-off signal, in our view. And China is less supportive for risk-on, as rising inflation will trigger policy tightening. Recent price action suggests US growth may be better than expected, countering the downside risks. The sharp rise in US Treasuries over the past two weeks — the 10Y is up over 40bps — is due entirely to real rates; inflation expectations have declined. Add to that the US dollar rally, and the market may be expecting stronger real growth, a view shared by our economists. This may also indicate that growth has taken over from QE as the main market driver. In our view, this upside risk is enough to balance out the increased downside risks elsewhere. While we’ve dialed back our constructive view on risky assets considerably, we still see near-term upside. The probability and magnitude of a correction has increased because of the rise in European sovereign and EM inflation risks. Yet we view these as downside risks, not the base case. The EM over DM gap should shrink in a risk neutral environment, but we don’t expect a performance reversal in the near term. November 16, 2010 Global Debates Playbook Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Shifting to Neutral on More Balanced Risks – + GBP ● EM credit ● EM currencies ● Oil ● Commodities ● EM equities ● Europe equities ● Gold ● US credit ● EUR ● US Treasuries ● USD ● Europe credit ● German Bunds ● JPY ● Asset Class Views
  2. 2. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 2 Table of Contents Global Cross-Asset Strategy Group 1 Morgan Stanley & Co. Incorporated 2 Morgan Stanley C.T.V.M. S.A. 3 Morgan Stanley & Co. International plc 4 Morgan Stanley India Company Private Limited 5 Morgan Stanley Asia Limited 6 Morgan Stanley Australia Ltd 7 Morgan Stanley MUFG Securities 8 Morgan Stanley Taiwan Ltd + Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Global Cross-Asset Strategy Market Commentary 3 Global Cross-Asset Strategy Overview 7 Investor Debates 8 Asset Class Base Case Views 10 Risk-Reward Views: Economics Global Economics 14 US 15 Europe 16 Japan 17 China 18 Asia ex-Japan 19 Brazil / Latam 20 India 21 Russia 22 Risk-Reward Views: Strategy US Rates 23 Europe Rates 24 UK Rates 25 EM Fixed Income 26 FX 27 Developed Market Equities 28 Europe Equities 29 Japan Equities 30 Asia / GEMs Equities 31 China (and Hong Kong) Equities 32 Global Corporate Credit 33 Securitized Credit 34 Commodities: Oil 35 Global Equity Derivatives 36 Global Credit Derivatives 37 Volatility Across Asset Classes 38 Economics Joachim Fels3 +44 (0)20 7425 6138 Dick Berner1 +1 212 761 3398 Elga Bartsch3 +44 (0)20 7425 5434 Robert Feldman7 +81 3 5424 5285 Takehiro Sato7 +81 3 5424 5367 Qing Wang5 +852 2848 5220 Chetan Ahya5 +65 6834 6738 Gray Newman1 +1 212 761 6510 Strategy Jim Caron1 +1 212 761 1905 Laurence Mutkin3+ +44 (0)20 7677 4029 Rashique Rahman3+ +44 (0)20 7677 7259 Stephen Hull3+ +44 (0)20 7425 1330 Gerard Minack6+ +612 9770 1529 Graham Secker3+ +44 (0)20 7425 6188 Alex Kinmont7+ +81 3 5424 5334 Jonathan Garner3+ +44 (0)20 7425 9237 Jerry Lou5+ +852 2239 1588 Greg Peters1 +1 212 761 1488 Vishy Tirupattur1 +1 212 761 1043 Hussein Allidina1 +1 212 761 4150 Sivan Mahadevan1 +1 212 761 1349
  3. 3. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 3 Shifting to Neutral as Increased Downside Risks Balance the Upside from QE and Growth Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com We move from full ‘risk-on’ to a more balanced risk on / off view. We’ve based our risk-reward assessment on three pillars: (1) US growth; (2) European sovereign risk; and (3) the China ‘Goldilocks’ scenario (see Exhibit 1). All three were flashing green for risk-on a few weeks ago, though our view was driven by the mantra: “don’t fight the Fed.” That hasn’t changed as we assess the US outlook. But the growing likelihood that Ireland will go the EFSF fund and the contagion risk that this poses for the euro periphery is a risk-off signal, in our view. The third pillar, China and EM, is also less supportive for risk-on, as rising inflation will trigger policy tightening. But the real risk is a replay of 2008, in which overheating could lead to a hard landing. Increased volatility is likely as markets digest news on sovereign risk and EM inflation, particularly on the policy front. The uncertainty about the fate of Ireland and the rest of the euro periphery leaves markets susceptible to large swings on any news or rumors. The same is true as investors assess the magnitude of inflation in EM and the risk of overheating. In both cases, policy is a major market driver. In Europe, containing sovereign risk depends on euro periphery governments taking tough fiscal actions and the EFSF serving as a “circuit breaker” for systemic risk. In EM, policy-makers have to walk a fine line between tightening too little and too much. Given all this, the risk of a policy error is high, and that adds to both volatility and downside risk. Recent price action suggests the market may be anticipating better US growth, countering the downside risks. The sharp rise in US Treasuries in the past two weeks — the 10Y is up over 40bps — after the Fed’s announce- ment on QE has caught many investors by surprise. What’s most noteworthy is that rise in yields has been entirely in real rates; inflation expectations have declined (Exhibit 2). Add to that the US dollar rally, and the market may be expecting stronger real growth, not higher inflation, a view shared by our economists (see Trade Tailwinds: Coming Strongly in Q4, November 5). Moreover, the nearly 20bps rise in the 2Y suggests a marginal change in the view that the Fed will be on hold indefinitely. Position unwinding likely accounts for some of the rate move post-announcement. But the markets may be transitioning from QE to growth as the main market driver. In our view, this upside risk is enough to balance out the increased downside risks elsewhere. Exhibit 1: Two of our three market pillars have moved toward risk off… Theme Where Do Things Stand? Risk On / Off? US Growth • “Don’t fight the Fed” — growth gets a pass for a little longer Risk on Sovereign Debt Crisis  Ireland going to the EFSF appears imminent, contagion looms Risk off China / EM  China ‘Goldilocks’ scenario nearing an end Risk neutral Exhibit 2: …but the sharp rise in real rates may be a signal of better growth Source: Bloomberg, Morgan Stanley Research 1.5% 1.6% 1.7% 1.8% 1.9% 2.0% 2.1% 2.2% 2-Aug 6-Sep 11-Oct 15-Nov 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 10Y Inflation Expectations (lhs) 10Y Real Rates (rhs)
  4. 4. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 4 If, or When, Ireland Goes to the EFSF Is Not Sufficient to Eliminate Contagion Risk Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com Ireland is likely to go to the EFSF stability fund very soon… Pressure on Ireland from Germany and other eurozone governments to restructure is mounting, driven by fears of contagion spreading through the bond markets. Likewise, the ECB is pushing Ireland to go to the EFSF because Irish banks have lost access to market funding and now rely on emergency lending support from the ECB. If Ireland resists — it’s funded until next summer and has a cash buffer — or it reaches an agreement that does not include a credible bank recapitalization plan, risk-off sentiment will continue to weigh on markets. …but that still leaves uncertainty in the credit markets and contagion risk. The ideal solution, outlined by our colleague Joachim Fels, is for Ireland to go to the EFSF, where it could borrow at a subsidized interest rate of 4-5% and use the loan proceeds to recapitalize and restructure the banking system (see Morgan Stanley Strategy Forum, November 15). But even in this situation, it’s not clear if the markets will fund Portugal and Spain, who don’t have similar cash buffers. In fact, banks in the euro periphery already rely heavily on lending support from the ECB (Exhibit 3). Plans to install a permanent crisis resolution mechanism to replace the EFSF in 2013 is another market headwind. The CRM would include a government bailout facility similar to the EFSF. But the crucial difference is that it would share the burden with private creditors in a crisis, in the form of voluntary maturity extension, interest-rate holidays or even haircuts. The possibility of the latter, which is apparently off the table for now, is adding to investor anxiety about lending, even now. The EFSF buys time, but the structural problems still must be addressed. Lending to the euro periphery now is designed to support fiscal adjustment, structural reform, and the recapitalization of banks. The dual goals are to put public sector debt on a sustainable path and to enable the country to return to private sector funding at a reasonable cost. Failure to meet these objectives in the next few years may result in a further extension of loans, but eventually the political will for doing so won’t be there. More drastic outcomes then become likely. In the near term, Exhibit 4 lists a number of events that can either mitigate or exacerbate sovereign risk, and with it risk-on sentiment. Exhibit 3: Euro periphery banks disproportionately access ECB liquidity Exhibit 4: Sovereign risk signposts to watch Source: BIS, Morgan Stanley Research 0% 10% 20% 30% 40% 50% 60% 70% Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 ECB total liquidity provision: GIPS banks / eurozone banks Total bank assets: GIPS / Eurozone Source: ECB, Morgan Stanley Research Category Event Date Ireland • By-election for a seat in Parliament • Presentation of detailed 2011 budget • Budget vote • Nov. 25 • Nov. 28 • Dec. 7 Eurozone finances • Eurozone finance ministers meeting • EU finance ministers meeting • Nov. 16 • Nov. 17 Crisis Resolution Mechanism • German proposal on future CRM • EU Commission takes up the proposal • mid-Nov • mid-Dec
  5. 5. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 5 Inflation Risk in Emerging Markets and the Policy Response Could Trigger a Replay of 2008 Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com There are inflation parallels to 2008, but also differences. QE is the target of much criticism, particularly in Asia, which is awash in inflation fears. By some measures, commodity prices are higher than their peak in 2008 (Exhibit 5). This risks repeating the experience of 1H08, when abundant liquidity, good fundamentals, and surging commodity prices led to huge inflationary pressures in EMs. In response, policy-makers were tightening aggressively going into the global recession triggered by Lehman’s bankruptcy. The difference for EM policy-makers today is that any tightening will occur while the Fed is starting a new round of QE, which presents additional challenges. The form, not just the magnitude, of policy tightening matters, in China. Our China economist Qing Wang believes that if China relies on rate hikes or currency appreciation, it should be fine. But if the authorities are reluctant to allow a rapid rise in either, as has been their preference in the past, they would need to cut back on the supply of new credit. Given the magnitude of monetary overhang (Exhibit 6), this would require a drastic cut to make a meaningful difference in inflation expectations, which have risen with QE. That is the risk: inflation in China tends to be tamed only after drastic credit controls, which cause more harm to the real economy than either rate hikes or CNY appreciation. The markets may react more to what the PBoC does next than the Fed. Investors are debating whether policy tightening in EM could be the trigger to end the risk-on trade. We don’t believe that will be the case, given the still ample liquidity globally. However, as now one of the main engines of global growth, China tightening could cause a market correction, even if it helps to avoid overheating. Markets have often paused or modestly corrected following the initial Fed rate hike at the beginning of a tightening cycle, but performed well starting in about 6 months. The PBoC may take on that role now in this cycle. Exhibit 6: Until M1 growth returns to trend, inflation pressure will persist Exhibit 5: The CRB commodity index is above pre-crisis high Source: CEIC, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research -15% -10% -5% 0% 5% 10% 15% Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 -4% 0% 4% 8% 12%% Deviation of M1 from the trend (lhs) CPI %YoY (rhs) Forecast 180 244 308 372 436 500 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 10 33 56 79 102 125 148 W TI US$ Per Barrel (RS) CRB Food Index (LS) CRB Commodity (LS)
  6. 6. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 6 Our Asset Class Views Reflect the Move to Risk Neutral Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com We’ve dialed back our constructive view on risky assets considerably but still see near-term upside. The probability and magnitude of a correction has increased because of the rise in European sovereign and EM inflation risks. Yet we view these as downside risks, not part of our base case. The combination of QE and signs of improving US growth should continue to provide risky assets with a tailwind, but the risk-reward is more modest than a month ago. The EM over DM gap shrinks in a risk neutral environment. Investors are starting to ask whether DM can finally outperform EM, especially with the start of policy tightening in China. We expect the performance gap to shrink as risk is dialed back, but no performance reversal in the near term. However, it is important to differentiate between EM equities and fixed income. Our EM equity strategist Jonathan Garner recently scaled back his overweight, roughly analogous to “sell into strength” (see Start to Scale Back OW Equities, October 18). In contrast, our EM fixed income colleagues upgraded their view to neutral/bullish, looking effectively to “buy on dips” (see Global EM Investor: Credit, Rates & Currencies, November 10). Investor positioning and strategic behavior could be a near term technical headwind. Many investors are positioned with the same risk-on QE trades: short the USD and long commodities and the belly of the Treasury curve. With sovereign and inflation risks back on the table, investors are asking when the risk-on trade will end. Proactively repositioning for this outcome could itself trigger ‘risk off’ market moves. For instance, some of the recent moves in Treasury rates reflects repositioning post-QE. Adjustments to our asset class views reflect the balanced risk on/off skew. We continue to favor equities over bonds generally. There is low upside to bonds, despite QE, and the sell-off in Treasuries last week while equities also fell is a reminder that bonds are far from risk-free. The main changes to our views over the past month, aside from a general scaling back of risk, are: • USD and EUR both moved to neutral from extreme negative and positive, respectively. QE remains a headwind for the USD, whereas rising sovereign risk reinforces its safe-haven status, while weakening the EUR. • Commodities, while still attractive on tightening supplies, are reduced a notch on USD strength and potential EM overheating risk.
  7. 7. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 7 Global Cross-Asset Strategy – Overview Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com What’s Changed: Increased downside risks, and less near-term upside • Global growth looks stronger than even a month ago and the global output gap is shrinking. This positive development is offset by greater risk of EM overheating due to surging capital inflows and policy makers who may fall behind the curve in fighting inflation. This increases DM “bad inflation” risk. • Sovereign risk in Europe is back, with Ireland posing contagion risks to periphery bond markets because of an undercapitalized banking system. Portugal’s weakness due to structural problems makes it likely to go to the EFSF as well. • Rising currency tension is a downside risk if it constrains capital flows and trade, but EM currencies, if they continue to rise, are a counter to inflation risk and ultimately help global rebalancing. Base Case: The risk-reward outlook is balanced between risk on/off; cautiously positive on risky assets • QE is forcing investors out on the risk spectrum, providing support for risky assets. We expect this to continue into 2011. However, QE provides a cyclical floor rather than a cyclical lift for the economy. • For markets to continue grinding higher into 1Q11, growth will become more important. The US growth outlook continues to improve to a sustainable level; 3.5% GDP in 4Q. • Inflation rather than deflation is more likely in the US, due to better growth (good inflation) and partly from DM importing higher inflation from EM (bad inflation) – the latter being a consequence of QE spilling over into EM and higher commodity prices. • An improving growth outlook and rising inflation expectations will favor equities over bonds, generally • QE is likely to affect policy in other countries, but in different forms. Only Japan and possibly the UK are likely to engage in actual QE; other countries in DM and EM will be slow in raising nominal rates, keeping real rates low. Global liquidity stays abundant well into 2011. • Sovereign risks in Europe remain elevated until Ireland goes to the EFSF and has a credible plan for recapitalizing and restructuring its banking system to limit contagion risk. Portugal is likely to follow Ireland. Focus returns to Spain, which will have to address its banking problems. • EM growth stays strong, but rising inflation and commodity prices increase the risk of overheating and odds of sharp policy tightening, repeating 2008. Capital inflows continue to provide strong technical support for EM assets. Rising commodity prices could differentiate between EM winners and losers based on who’s a producer versus consumer. • Continue to favor EM over DM, although the gap shrinks in a risk neutral environment. No clear catalyst for a performance reversal in the near term. Risk On/Off Skew: Neutral to negative bias R isk O ff N eutral R isk O n T his M onth Last M onth Strategic Asset Class Views – + GBP ● EM credit ● EM currencies ● Oil ● Commodities ● EM equities ● Europe equities ● Gold ● US credit ● EUR ● US Treasuries ● USD ● Europe credit ● German Bunds ● JPY ●
  8. 8. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 8 Investor Debates Risk on or off?  What’s the catalyst to end the ‘risk on’ trade? When will ‘risk on’ end? Has that happened already?  Will ample liquidity continue to support markets or is asset reflation due to QE already priced?  Is evidence of improving growth enough to counter increased sovereign and EM overheating risks?  Can events in EM be the trigger for risk off even if DM growth is ok and liquidity is abundant? US outlook & QE  What impact will QE have on the economy?  Based on recent economic data, and the increase in rates, will growth be better than expected?  Will the Bush tax cuts be extended? Is the policy gridlock in Washington a positive for the markets?  Can the Fed tolerate higher inflation and risk asset bubbles, especially given international pressure?  How significant is the potential negative feedback loop from QE (e.g., importing inflation)?  How long will investors give growth a “free pass” before expecting to see benefits from QE? Sovereign debt crisis  When and what will cause Ireland to go to the EFSF / IMF?  How long will the ECB continue to support Irish banks before forcing a fiscal solution?  Will Portugal quickly follow Ireland’s lead in going to the EFSF?  If Ireland goes to the EFSF, will it be a ‘circuit breaker’ by recapitalizing its banks or trigger contagion?  What form and final impact will the proposed Crisis Resolution Mechanism have?  How extensively will contagion spread to Spain? To the euro core? China / EM overheating & FX  How at risk is China of overheating? Will tightening lead to a soft or hard landing?  How widespread is the risk of overheating across EM?  How serious will the currency war get? How likely are further capital controls?  Which countries will respond to QE by raising interest rates (and FX) and which will risk inflation?  Which countries will be the winners and losers from QE, stronger currencies, and higher commodity prices? Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com
  9. 9. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 9 Investor Debates by Asset Class Rates  Why have rates across the Treasury curve gone up since the Fed announced QE details?  Will rates decline, and by how much, once the Fed starts to purchase Treasuries?  Will euro-periphery spreads continue to widen on contagion fears?  What happens to spreads in the core if a periphery country taps the EFSF fund?  With rising inflation risk in EM and large capital inflows, what happens to credit spreads and local rates? FX  Will the USD continue to strengthen on better growth and ‘risk off’, or weaken again on QE?  Can the EUR strengthen despite sovereign risk problems?  Will China allow the CNY to appreciate faster to fight inflation and alleviate global pressure?  Which EM countries will try to keep their currencies from rising?  How will currency tensions be resolved? Will there be coordinated policies?  How long will the USD remain the main reserve currency? What are the alternatives to replacing it? Equities  Have equities fully priced in the benefits of QE? Can the rally only continue if growth improves?  Would Ireland going to the EFSF lead to a significant correction? Even if growth is still surprising to the upside?  Are EM equities at risk of a correction on tightening concerns?  Is DM more attractive than EM, given overheating concerns? Can high-beta EM fall while DM is rising?  Will multiples contract if growth doesn’t improve? Credit  What does QE mean for corporate credit with yields already so low?  What’s the risk to credit from companies doing shareholder-friendly activities (M&A, buybacks, dividends)?  What does Basel III mean for hybrids and Tier 1 capital?  How is bank debt / RMBS affected by the mortgage foreclosure crisis and mortgage put-back problem? Commodities  How much more will QE and lower USD drive up commodities?  With tightening supply and stronger EM growth, how high could commodities go?  Will gold continue going higher because it is an inflation hedge against QE and a risk-off hedge? Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com
  10. 10. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 10 Asset Classes Base Case Views Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com Trades • Long front-end forward rates to benefit from rolldown and carry with the Fed likely on hold for a while • Overweight the belly of the curve; the 5-10yr sector is expected to outperform, boosted by Fed purchases • We now like being short volatility on 5s and prefer to move our long variance trade to 30y tails • Long low coupon vs. high coupon in Greece, Portugal, Spain, UK (cheap insurance against contagion) • Long Italy, Spain, France and Belgium vs. short Portugal, Ireland, and Netherlands • 5s to underperform on the Bund curve, 10s to outperform • Gain exposure to EM growth through Argentina warrants and O&G sector • Favor high-beta (Central and Eastern European countries, Ukraine, Argentina) over low-beta credits . • We see the 10Y trading in a range of 2.25% to 2.85% in the near term, with rates likely to fall once Fed purchases begin. • Fed purchases will cause the belly to outperform further as the bulk of the purchases are in the 5-10y sector. We expect the 2s10s curve to flatten close to 2.00 while the 10s30s could continue to steepen. • A headwind for lower rates is the negative feedback loop, driven by higher inflation in AxJ due to excess liquidity. Inflation could flow back to the US in the form of higher commodity prices, but also a decline in foreign ownership. • We expect interest rate volatility to increase further out on the curve (30y), and to fall in the belly. • Reversing our underweight of euro peripheral vs. core for 3 reasons: 1) tactical trading model has its smallest underweight to peripherals for 5 quarters; 2) potential regulation of financials may support peripheral bonds; 3) downside risks to peripherals are lower for investors measured against a pan-Europe index. • In EM, we move our directional stance to neutral/bullish. Metrics reveal signs of stability in EM macro-fundamental trends. This development supports the case for building strategic long-side EM risk positions into 2011. EM risk market remains short-term overbought but valuation metrics suggest more compelling entry levels. Rates / Sovereign Credit Views • With improving global economic conditions contrasting with the Fed’s easing move, there may be near-term upside risks for higher-beta currencies in the G10. Our preferred currencies are CHF, GBP and SEK. • We are now in the final stages of USD weakness and EUR is generally trading with the core. The key risks to this call are US economic data outperforming and German data underperforming. Unless peripheral concerns begin to have an impact upon the core, we expect that peripheral issues will not have lasting impacts upon EUR/USD, although they may increase volatility going forward. • We take a cautious approach by looking for other European outperformance against the EUR. We look for CHF to be the biggest beneficiary from any concerns surrounding the Eurozone, while SEK should also benefit due to the strong fundamentals and dual surpluses of both currencies. • We like GBP tactically as we believe QE expectations will continue to be priced out in the short-term leading to GBP benefit as it contrasts with the rest of the G4 as GBP is not hampered by QE and the UK takes control of its fiscal problems. FX Trades • Short EUR/CHF (1.28) • Long EUR/USD (1.46) • Short EUR/SEK (8.88) • Long GBP/JPY (134.50) • Short MS Dollar Index (65.00) • Long MS AxJ Index (120.00) – + CHF ● GBP ● SEK ● KRW ● CAD ● SGD ● CNY ● NOK ● EUR ● USD ● NZD ● AUD ● JPY ● Views – + US duration ● EU volatility ● US volatility ● US spreads ● EM spreads ● EU curve ● EM local dur. ● EM local curve ● EU duration ● US curve ● EU spreads ●
  11. 11. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 11 Asset Classes Base Case Views Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com Equities • Tactically constructive on DM and EM equities, any pullback should be modest. • Post-QE announcement, US growth will be the main driver for equities moving higher, while QE will continue to provide a cyclical floor to the market. • Elevated sovereign risk and the potential for contagion in Europe is a headwind for equities; this is likely to remain until there is some resolution with Ireland initially and then the rest of the euro periphery. • Rising inflation in China and other countries in AxJ, exacerbated by QE, could trigger significant tightening – otherwise risk overheating. We would look to reduce an EM overweight given the potential for a corrective phase. • Longer-term, we expect DM equities to trade in a broad range for an extended period for 3 reasons: 1) that’s what usually happens after big bear markets; 2) valuations point to low returns; and 3) we expect a sub-par macro cycle. • Near-term, DM equities have reasonable valuations and attractive yield, but investor sentiment is reaching elevated levels. • Valuations are fair, particularly in Europe – approx. 10.5x 2011 IBES P/E, earnings growth leading indicator predicting 48% earnings growth NTM • High dividend yields for the S&P 500 and MSCI Europe – comparable to the 10Y Treasury yield – are supportive for prices as investors seek yield • Expect companies to start putting to work near-record cash holdings in increased dividends and buybacks, and M&A, though more so in 2011 • Earnings forecasts for 2011 are optimistic, but haven’t increased since the spring and significant downward revisions are less likely. • Flows out of equities and into bonds are slowing and likely to reverse in 2011 if rates start to rise, providing a technical tailwind for equities. • EM equities are increasingly less attractive after a 35% return to MSCI EM since May and rising inflation and tightening risks. Valuations are in-line or slightly above long-run averages. • Technical support from Asia / EM funds – 23 consecutive weeks of positive flows – but the markets are technically overbought and there is a big wave of secondary placements from corporates in the pipeline. Trades Europe • Add some beta – e.g., Financials & Commodities. • Superior EM growth – Energy and Materials offer better value than Staples and Capital Goods. • Reliable growth stocks should be long-term winners, however value stocks should outperform in the short- term if the market rallies. • Dividend strategies – we like high and secure dividend yielders; stocks where DY > credit yield; index dividend swaps. Japan • Buy domestic demand super-large caps: Large has underperformed small; super-large (Core 30) has underperformed large; within the Core 30 of Topix, domestic demand stocks have underperformed. EM • Overweight consumer discretionary as a play on development of urban middle class and rising wages. • Overweight upstream Asia / EM energy • Underweight telecoms, utilities and healthcare • In China, overweight high-beta sectors – properties, material, banks, and insurance – and underweight transportation, consumers, auto, and technology. Thematic • Long Large Cap Quality • Long DM equities with high leverage to EM growth • Long Dividend Yield / Reliable Growth Views Europe – + Materials ● Energy ● Financials ● Telecom ● Industrials ● Tech ● Cons Staples ● Healthcare ● Utilities ● Cons Disc ● EM – + China ● Malaysia ● Russia ● Korea ● Taiwan ● India ● Brazil ● Indonesia ● South Africa ● Turkey ● Mexico ●
  12. 12. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 12 Asset Classes Base Case Views Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com Credit / Spread Product • Generally constructive – a low growth, low return world should keep DM credit in a relative “sweet spot,” with a lid on egregiously credit-unfriendly actions. • Financials should lead the way with ongoing credit repair, especially in Europe, and benefit as banks call/tender Tier 1 paper. However, the size, timing and scope of GSE MBS putbacks to US banks is a new headwind to credit valuations. • Attractive valuations and strong corporate fundamentals in non-financials provide a margin of error against higher loss rates, but volatility is likely to remain high. • Headwinds for credit are (1) low Treasury and Bund yields that have driven corporate bond yields to historic lows, constraining further spread repair; and (2) with low yields on QE, we see a pickup in shareholder friendly activity (i.e., moderate increase in LBOs) as likely. • The front end of the credit curve is more attractive based on current stage in the default cycle, spread per unit of duration, and roll down and carry. • Net shrinkage in supply and fund flows are positive technicals; fully invested investors and positive supply are near-term headwinds in Asia. • For non-agency RMBS, the market is pricing in much harsher outcomes than the collateral is currently and expected to perform. This provides a substantial positive convexity potential. For CMBS, the two most senior classes of the synthetic CMBX indices, AAAs and AMs, remain cheap to fair value, while the AJs and below are extremely rich Trades • Overweight US & Asia, neutral Europe. • Long Financials, and extend out the maturity curve. Tier 1 in Europe and Asia remains a core overweight. • Quality HY is cheap relative to low-quality IG in the US: overweight BBs vs. BBBs. The same applies to Asia. Buy 3s5s steepeners in selected US HY. • Long the HY ‘tails’ (CCCs) relative to high quality. • Put spread collars in iTraxx Main and Senior Financials to play sovereign volatility. For large tail scenarios, put spreads in CDX IG and risk reversals in CDX HY. • Long senior tranches of non-agency RMBS (subprime and alt-A). • Long CMBX.3 AM and short CMBX.3 A; expect to see substantial steepening here. • All CLO tranches are cheap compared to the underlying; particularly bullish on CLO mezz. Commodities • With refinery maintenance having peaked, we anticipate further crude draws ahead, which together with a still favorable macro environment should lift oil prices higher into year-end. • Our updated analysis of crude oil’s supply-side fundamentals portends falling spare capacity, which will propel prices above $100/bbl in 2011 to ration demand. • Agriculture prices have rallied and the corn balance is precariously tight. Prices will need to continue to move higher, to at least $6.00/bu for a sustained period, to ration demand and add acreage. Weather is still a significant risk to wheat. • The weakening of the US$ has been the major factor in the current metals rally, although the impact of the strengthening in the global manufacturing sector as evident in the latest PMIs should not be underestimated as a factor in the sustainable strength of metal and bulk raw material prices. Trades • Good risk/reward in being long crude, specifically Dec’11 WTI, with prices very likely to move north of $90/bbl by year-end. • Seek exposure to stockpiling ahead of China’s H1 production/consumption cycle, (coal and iron ore). Strong conviction on copper and nickel, avoid aluminium and zinc. • Add exposure to corn (Dec’ 11) but shy away from wheat as weather is the biggest driver. • Add gold to the precious metals basket for protection against a USD under pressure, palladium for a greater risk appetite – + Agriculture ● Precious metals ● Oil - WTI ● Gold ● Bulk comm'd ● Base Metals ● Natural Gas ● Views Views – + US HY ● CLO ● Asia Financials ● US Financials ● Asia HY ● RMBS ● EU Financials ● Asia IG ● US IG ● Europe IG ● CMBS ● Europe HY ●
  13. 13. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 13 Risk-Reward Views Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com
  14. 14. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 14 Global Economics Risk-Reward View Investor Debates  QE2: will it work? Will other DM central banks follow the Fed? How will EM policymakers react?  Global growth: merely moderating or double-dipping? Key focus on US and China trajectory in 2H 2010 and 2011.  Inflation or Deflation? What is more powerful – deleveraging or massive monetary stimulus? What’s in the price?  Equity and credit markets have rallied on the prospect of QE2, and, while the bond market is looking for the QE2- consistent level of yields, the dollar has weakened.  Risky assets are pricing growth moderation, but no DD.  QE2 has raised inflation expectations from low to more moderate levels. Signposts After G20 summit US Tsy semi-annual currency report By 4Q PBoC to revise up 2010 target for new bank lending (currently RMB 7.5trn) December Greece: 3rd disbursement of € 9Bn 2010-11 China currency manipulation bill to go before Senate Joachim Fels, Manoj Pradhan, Spyros Andreopoulos (44 207) 425-6138, joachim.fels@morganstanley.com Key Indicators GDP Growth: Not Double-Dipping, Moderating -10 -8 -6 -4 -2 0 2 4 6 Mar-00 M ar-02 Mar-04 M ar-06 Mar-08 M ar-10 M ar-12 G 10 G DP QoQ SAAR G 10 CPI YoY G 10 Policy Rate ForecastsG10 Source: Morgan Stanley Research 2010 2011 2012 2013–2017 Global GDP Bull 5.4 5.9 5.0 Base 4.7 4.2 4.4 4.1 Bear 3.0 2.9 3.0 DM GDP Bull 3.2 3.8 2.7 Base 2.4 2.1 2.4 2.1 Bear 0.9 0.9 1.4 EM GDP Bull 7.9 8.2 7.4 Base 7.3 6.5 6.5 6.1 Bear 5.2 4.9 4.5 Global Inflation (CPI) Bull 4.0 4.3 3.8 Base 3.3 3.2 3.2 3.1 Bear 2.5 2.5 2.4 Base Case / Thesis 2011 Global GDP: 4.2% Just say no to the double-dip Cyclical momentum in the Euro Area and the UK is still strong, and we are looking for a pickup in US growth next year. Fiscal tightening is less widespread than generally believed and may crowd in private spending. Importantly, with the Fed engaging in QE2, global monetary policy remains super-easy. Central banks: The Big Easy Fed, ECB, BoJ all remain super-expansionary into 2011, and EM CBs’ ability to tighten is thus limited due to concerns about excessive currency appreciation. China is even starting to relax credit policy. Sovereign risk concerns to spread into the European core and, eventually, to migrate to the US as most governments lack resolve to tighten policy significantly. This raises the temptation to inflate away the debt.  Bull Case 2011 Global GDP: 5.4% A stronger capex and inventory cycle could boost global output and trade. Commodity prices would skyrocket, fuelling inflation concerns and leading to more aggressive monetary tightening.  Bear Case 2011 Global GDP: 3.0% Growth in China/Asia falters in response to monetary tightening, aborting the strong global trade recovery, pushing commodity prices lower. Protectionism could also be a policy response. Fiscal positions would deteriorate further, making a large-scale sovereign risk crisis even more likely.
  15. 15. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 15 US Economics Risk-Reward View Investor Debates  Double-dip and deflation fears have eased, reflecting the onset of QE2. But tail risks are not zero: Recent data have been mixed.  Policy intractability: Fiscal policy appears gridlocked, although an extension of expiring tax cuts is likely at some point. The economic impact of additional easing likely will be modest.  Sovereign credit concerns: When will spotlight turn to the US? What’s in the price?  Near term, our trading desk does not think that QE2 is fully in the price, and yields may decline to 2.3%. Equally, with monetary policy driving yields, it is difficult to determine whether or not real yields reflect market expectations for growth. But rising breakevens do reflect some longer-term upside for inflation, something the Fed welcomes. Signposts November 15 “Lame duck” session of Congress begins December 3 November employment situation December 14 FOMC meeting Key Indicators Two Scenarios for Growth in 2011 Base Case / Thesis 2011 GDP: 2.7% Subpar growth, but consensus is too dour. Four factors will sustain growth at 2-2½% in H2: (1) a rebound in net exports; (2) solid growth in personal income; (3) a modest refinancing wave; (4) rising infrastructure spending. We still think that the US economy remains on track for moderate, sustainable growth in 2011. QE2. We expect the Fed to announce an initial commitment to buy Treasuries at around a $100 billion monthly clip for the next six months. Going forward, the Fed likely will adopt a flexible approach to QE that can be scaled to economic and financial conditions. Nevertheless, the fractures in the monetary policy transmission mechanism mean that QE won’t yield much bang for buck. QE2 will push nominal yields lower. We believe that the actual start of the program will trigger further significant declines in Treasury yields, especially if the Fed is as resolute as its prior rhetoric.  Bull Case 2011 GDP: 3.8% Improving income and another increase in mortgage refinancing activity should bolster household cash flows and add to discretionary spending power. Overall final demands look set to accelerate and historically low levels of business inventories (in relation to sales) point to production gains. A rebound in inflation expectations could prompt a much more rapid exit by the Fed than is now priced in.  Bear Case 2011 GDP: 1.6% Even larger home price declines, the “sunset” of the Bush tax cuts, and continued moderation in job growth could weigh on growth. If the economic recovery falters, the unemployment rate will climb significantly, credit-related losses will mount, and risk aversion will predominate. These developments would reinforce deflation fears and compel the Fed to undertake more significant QE. Source: Bureau of Economic Analysis, Morgan Stanley Research estimates 2009 2010 2011 2012 GDP Bull -2.6 3.0 3.8 4.8 Base 2.7 2.7 3.2 Bear 2.4 1.6 1.6 CPI -0.3 1.8 2.4 2.9 1.6 1.8 2.2 1.5 1.3 1.5 Unemployment 9.3 9.6 8.4 7.6 9.7 9.2 8.3 9.8 10.0 9.0 Policy Rates (EOP) 0.125 0.50 1.50 3.50 0.125 0.125 2.50 0.125 0.125 1.00 1.5 2.0 2.5 3.0 3.5 4.0 1Q10A 2Q10A 3Q10E 4Q10E 1Q11E 2Q11E 3Q11E 4Q11E MS Base Case (October 2010) MS "Full Sunset" Scenario (October 2010) US Real GDP Growth (Quarterly % Change, SAAR) Richard Berner, (212) 761-3398, richard.berner@morganstanley.com
  16. 16. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 16 Europe Economics Risk-Reward View Investor Debates  Will Portugal/Ireland have to tap the EFSF? Will the crisis resolution mechanism replacing the EFSF in 2013 pave the way for a debt restructuring? – When/how will the ECB move towards the exit? Is the ECB done buying peripheral government bonds? – Could Germany see a consumer revival given its strong labour market performance? What’s in the price?  GDP growth of 1.6% this year, around 1.4% next year. Subdued inflation pressures (5Y/5Y fwds at 2.14%).  ECB starting to gradually raise rates in H2 2011.  Ten-year bund yields to continue to move higher. Consensus forecasts are for 3% in late 2011. Signposts November 16 & 17 Eurogroup Meeting Ecofin Council Meeting UK MPC Minutes November 23 & 24 France INSEE Mfg survey Germany Ifo index Late November Troika to judge Greek progress December 2 ECB Council Meeting & Press Conf December 6 Eurogroup Meeting Budget Ireland Ecofin Council Meeting December 9 UK MPC Meeting Elga Bartsch, (+44) 207 425 5434, elga.bartsch@morganstanley.com Key Indicators Bull, Base, and Bear Cases – ECB Refi Rate Base Case / Thesis 2011 GDP: 1.4% Our base case is for growth momentum in the second half of this year to return to the trend range of the strong print in 2Q. Incoming activity data point to upside risks to our official forecasts for growth to return to trend in 2H 2010. The stronger than expected momentum is a welcome cushion against the impact of a stronger euro. Several factors support our call for a slowdown between this and next year. First, there will be additional fiscal tightening at the beginning of next year, notably in the large countries. Second, even though credit growth seems to have troughed the recovery remains creditless. Third, outside Germany, the euro area recovery still remains largely jobless. With both growth and inflation being modest over the forecast horizon, we expect the ECB to be on hold until early 2012.  Bull Case 2011 GDP: 2.3% Bold policy action would address the issues in the banking system and force recapitalisation/restructuring. ECB keeps liquidity ample. Borrowing costs come down substantially, helped by credible fiscal consolidation. Global growth is even stronger led by EM and more expansionary policies globally.  Bear Case 2011 GDP: 0.5% Policy inaction and looming bank losses lead to full blown credit crunch. Inventory and investment recovery reverts. Fiscal austerity forced by the market lacks credibility and the periphery marks new wides. Global growth peters out as no one is stepping into the void left by the US consumer. A global inflation scare propels bond yields higher. 2009 2010 2011 2011–2015 GDP Bull -4.1 1.8 2.3 2.6 Base 1.5 1.4 1.8 Bear 1.3 0.5 1.0 CPI 0.3 1.8 2.3 1.6 1.7 1.8 2.1 1.4 1.3 2.6 Unemployment Rate (%) 9.4 9.7 9.0 9.9 9.5 10.2 10.7 Policy Rates (EOP) 1.00 1.00 2.00 1.00 1.00 0.75 0.10 0 1 2 3 4 5 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Refi rate Base Case 2.00 1.00 0.10 Source: Morgan Stanley Research
  17. 17. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 17 Japan Economics Risk-Reward View Investor Debates  Will the yen weaken or strengthen?  Have JGB yields hit bottom?  Will politics change fiscal policy ? What’s in the price?  Investors are reluctant to take short-horizon strong-yen positions in yen/dollar, fearing intervention. JGB investors are waiting to see the DPJ’s stance on budget issues such as spending control, tax hikes, and civil service reform. Reduced BoJ independence would likely be welcomed by markets, and bring earlier yen weakness. Signposts Early November BoJ Law revision proposals discussed by a group in the ruling party and by opposition parties; pressure on BoJ continues. End-November Production, inventory, employment indicators announced late in the month; these will determine whether BoJ will be pushed toward increase of special fund. December Tax Debate Ruling party tax committee will debate corporate tax cut, elimination of special tax breaks, tax-loss carry- forward extensions, etc. Budget finalization Cabinet must approve draft budget for FY11 by end-December. Focal points: (a) whether new bond issuance will exceed the government’s declared Y44 trl ceiling, (b) spending control, (c ) Revenue projections. Robert Feldman, +81 3 5425-5385, Robert.Tokyo.Feldman@morganstanleymufg.com Key Indicators Yen/US$: Breakout only in end-2011 Base Case / Thesis ¥93/US$ (end 2011) BoJ remains behind the Fed in aggressiveness of easing stance, spurring continued yen strength. Although weak growth and continued deflation will spur more BoJ easing, we expect BoJ action to be slow and grudging, relative to other central banks. Only when deflation fears in US wane will we see reversal of yen strength We still see strong demand from duration matching needs will keep demand for JGBs strong. However, higher volatility has triggered “sell on strength” in JGBs, and put a floor under yields at around 0.9% for the 10yr JGB. Policy will drift as political disruptions continue. Credible direction will emerge only when politics settle, which could take several more months.  Bull Case ¥110/US$ US growth surprises on the strong side, pushing Fed to a stronger rate hike, while DPJ government pressures BoJ toward more easing. JGB yields rise as capital flows abroad; domestic investors show weaker home bias. Global growth strong enough to raise earnings sharply.  Bear Case ¥75/US$ US growth double-dips, Fed does QE3, while BoJ resists policy change. China slowdown hurts exports, harming earnings growth. Intervention by Japanese authorities might slow yen appreciation. Source: Morgan Stanley Research 2010e 2011 2012 2013–2016 GDP Bull 3.4 2.2 3.1 2.0 Base 3.0 1.0 1.7 1.0 Bear 2.7 -0.1 0.2 0.0 CPI (Japan Core) Bull -0.9 0.0 0.2 1.0 Base -1.0 -0.3 -0.2 0.5 Bear -1.1 -0.6 -0.5 0.0 Unemployment Rate Bull 5.1 4.7 3.9 3.0 Base 5.1 4.9 4.5 3.7 Bear 5.1 5.5 5.9 5.0 Call Rate (EOP) Bull 0.05 0.25 0.50 1.5 Base 0.05 0.05 0.25 0.5 Bear 0.05 0.05 0.05 0.05 2 0 0 8 2 0 0 9 2 0 1 0 2 0 1 1 7 0 7 5 8 0 8 5 9 0 9 5 1 0 0 1 0 5 1 1 0 1 1 5 7 0 7 5 8 0 8 5 9 0 9 5 1 0 0 1 0 5 1 1 0 1 1 5 Y e n / U S $ F o r c d a te 2 9 O C T 1 0 2 s d b a n d , b a s e d o n 1 0 0 d m - s d e v .
  18. 18. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 18 China Economics Risk-Reward View Investor Debates  Whether headline CPI inflation is peaking or would keep rising through the year. In the latter case, the probability of another interest rate hike will be rising.  Whether property prices would correct before year end– as supply comes on line–or resurge. In the latter case, the risk of another wave of austere measures would be high. What’s in the price?  A Goldilocks Scenario. Signposts December Early December, Central Economic Work Conference which will set the policy targets for 2011 Qing Wang, (852) 2848-5220, Qing.Wang@morganstanley.com Key Indicators China: Economy Regained Momentum Base Case / Thesis 2010 GDP: 10% 2010 – Goldilocks On Track: We expect headline CPI inflation to peak at 3.7-3.8%YoY in Oct-Nov 2010 before declining below 3.5%YoY in Dec 2010. We forecast GDP growth at 9.3% YoY (or 2.4% QoQ SAAR) in 4Q10 and 10.2% for the year as whole. Our calls include: a) no additional rate hike through year-end; b) bank lending target is unlikely to be relaxed significantly beyond the original target of Rmb7.5tn; and c) RMB appreciation against the USD to continue, reaching 6.60 by end-2010.  Bull Case 2010 GDP: 11% If a) external demand were to be substantially stronger than envisaged under our baseline scenario; and b) a major slowdown in private residential property construction would not materialize while the social housing program would take off, a full-blown overheating would become possible.  Bear Case 2010 GDP: 9.0% The strong export growth in 1H10 may well turn out to be transitory, and the subsequent export growth over the course of the year would slow sharply. Austere policy measures against speculation in property market may weaken construction activity substantially, while the social housing program may fail to fill the slack in 2H10, resulting in a hard landing in FAI growth. Source: Morgan Stanley Research 2009 2010 2011 2012–2016 GDP Bull 9.6 11.0 11.0 9.5 Base 10.0 9.5 8.0 Bear 9.0 8.0 6.5 CPI Bull -0.6 3.3 4.5 4.0 Base 2.8 3.0 3.0 Bear 2.3 2.0 2.0 Trade Balance (% of GDP) Bull 4.0 3.3 3.5 3.0 Base 2.8 2.2 2.0 Bear 2.3 1.5 1.5 9.5 7.5 7.1 15.1 12.7 9.8 9.2 8.3 10.0 2.8 11.1 0 4 8 12 16 20 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 GDP (QoQ, %, SAAR) Regained Momentum
  19. 19. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 19 AxJ Economics Risk-Reward View Investor Debates/Themes  Will China’s current stabilization of domestic demand continue? Will policy makers signal softening in policy stance or continue with policy rate hikes?  Will increasing food and commodity prices, strong growth and delayed policy exit result in inflation risk in AXJ?  Will regions’ policy makers respond with stringent capital control measures on rising capital inflows? What’s not in the price?  We expect China's policy rate hike to be one-off and expect policy makers to signal softening in policy stance in Q4- 2010, considering that the targeted moderation in demand appears to have been achieved.  We continue to see upside risk of inflation on strong growth, delayed policy exit and higher commodity prices.  If capital inflows were to become unmanageably high, some countries may initiate measures to discourage debt capital inflows, but not equity capital inflows. Signposts Nov 16 BOK’s monetary policy meeting Nov 30 India’s Quarterly GDP Chetan Ahya, +65 6834 6738, Chetan.Ahya@morganstanley.com Key Indicators CRB Commodity Index Above Pre-Crisis High Base Case / Thesis 2011 GDP: 8.2% In 2011, we expect GDP growth to remain strong at 8.2% (close to the trailing five-year average), compared with 8.9% in 2010 and 6.2% in 2009. We expect the region’s growth to be driven by domestic demand. We expect private consumption to continue to accelerate across the region. However, capex growth is likely to moderate in China as well as AxJ ex-China. Reflecting the relative strength of domestic demand, we expect the region’s net exports (as a percentage of GDP) to decline to 4.1% in 2011 from 4.3% in 2010 and the peak of 6.8% in 2007.  Bull Case 2011 GDP: 9.4% We believe the key driver that can influence our base case GDP growth forecasts positively would be an upside surprise in exports. Exports have already recovered above pre-crisis levels.  Bear Case 2011 GDP: 6.9% We think the key risk to our base case is any deterioration in EU’s sovereign debt concerns and/or US growth outlook, leading to a double-dip in the developed world. A double-dip in the developed world can pose downside risk to external demand and capital inflows. 2009A 2010E 2011e 2012e 2013–2017e GDP Bull 6.2 8.9 9.4 9.6 8.7 Base 8.2 8.0 7.6 Bear 6.9 6.4 5.8 CPI Bull 4.8 4.6 4.3 Base 2.4 4.8 4.0 3.6 3.5 Bear 3.3 2.8 2.3 Policy Rates (EOP) 4.5 5.0 5.7 5.8 CAB (% of GDP) 5.3 3.4 2.9 2.8 Fiscal Balance (% of GDP) -3.7 -3.8 -3.2 -3.2 Source: Bloomberg, Morgan Stanley Research. 180 244 308 372 436 500 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 10 33 56 79 102 125 148WTI US$ Per Barrel (RS) CRB Food Index (LS) CRB Commodity (LS)
  20. 20. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 20 Brazil / Latam Economics Risk-Reward View Investor Debates  While authorities have tightened exchange controls, raising the IOF tax on fixed income, equity fund, multi market fund and debentures capital inflows, BRL keeps strengthening. Can the authorities fight the rally?  Mid-cycle moderation or more worrisome sign? We believe Brazilian growth is strongly linked to global cycle. What’s in the price?  Brazil market is pricing in no more hikes this year and we agree, but we see another 175 bps of hikes in 2011 while the market sees 150 bps of tightening at most;  Equity and credit markets are once again showing significant strength and confidence that Brazil’s economy is likely to produce strong results this year and next. Signposts November 16 Chile – Monetary Policy Meeting November 19 Colombia – Monetary Policy Meeting October 26 Mexico —Monetary Policy Meeting December 1 Chile – Monetary Policy Minutes Peru – CPI (November) December 3 Colombia – Monetary Policy Minutes December 5 Colombia – CPI (November) December 8 Brazil—Monetary Policy Meeting Brazil – CPI (November) December 7 Chile – CPI (November) December 8 Mexico – CPI (November) Gray Newman, (212) 761-6510, Gray.Newman@morganstanley.com Key Indicators Brazil: Real GDP Growth (% change y-o-y) Base Case / Thesis 2010 GDP: 7.9% Brazil’s economy is slowing. After posting GDP growth at 11.4% annualized pace in the first quarter, the economy stalled in April through July—the stalling was hard to see given the momentum at the beginning of the second quarter which kept the average for the second quarter up 5.1% on annualized basis over first quarter. Part of the slowdown may be a mid-cycle moderation, especially after tax breaks accelerated consumption in the first quarter. But we suspect slowdown may also have been a reaction at the time to a more cautious global outlook. The slowing allowed the central bank to slow the hiking pace in July and signal hikes may have ended for the time being in September. We suspect growth will be strong enough in 2011 to prompt the central bank to restart hikes under next administration.  Bull Case 2010 GDP: 8.7% Given lags between monetary tightening and the economy’s response, more fiscal stimulus for longer and supportive global backdrop, Brazil’s growth rate in the second half bounces back after mid-year to pace similar to what was seen in the first fourth months of the year.  Bear Case 2010 GDP: 7.2% The bear case assumes the economy stalls in the second half of 2010—even in that case, the strong statistical carryover in early 2010 should produce a solid headline average growth rate. It assumes that global conditions turn less supportive, while domestic concerns on political developments increase. Although we have growth moving back to 3% range in 2011, the headline annual GDP report would likely post closer to 2%. Source: Morgan Stanley Research 2009 2010 2011 2011–2015 GDP Bull -0.2 8.7 6.3 5.0 Base -0.2 7.9 4.0 4.0 Bear -0.2 7.2 2.0 3.0 CPI Bull 4.3 6.2 6.0 5.5 Base 4.3 5.8 5.5 5.0 Bear 4.3 4.8 4.5 4.5 Policy Rates (EOP) Bull 8.75 12.25 15.75 NA Base 8.75 10.75 12.50 NA Bear 8.75 10.75 8.75 NA -4 .0 % -2 .0 % 0 .0 % 2 .0 % 4 .0 % 6 .0 % 8 .0 % 1 0 .0 % 1 2 .0 % J u n -0 4 M a r-0 5 D e c -0 5 S e p -0 6 J u n -0 7 M a r-0 8 D e c -0 8 S e p -0 9 J u n -1 0 M a r-1 1 D e c -1 1
  21. 21. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 21 India Economics Risk-Reward View Investor Debates/Themes Near term  Is market underestimating inflation and trade deficit risks in India? Medium term  Infrastructure – India’s long-term structural challenge now getting addressed, lifting sustainable growth rates.  Will India start outpacing China’s growth rates in 3-4 years’ time? What’s not in the price?  We remain bullish on India’s structural as well cyclical growth outlook. However, we believe accommodative monetary and loose fiscal policies have pushed growth higher than the near-term potential. Over the next 6-12 months, we believe that monetary policy and fiscal policy exit will need to stay on course to manage the macro stability risks of a large trade deficit, rising inflation expectations and low deposit growth in the banking system. Signposts November 30 GDP data for QE-September Next 6 Months Policy announcements on (1) divestment of the government’s stake in SOEs; (2) infrastructure sector including highways and electricity Chetan Ahya, +65 6834 6738, Chetan.Ahya@morganstanley.com Key Indicators BRIC: Two-year Trailing Average GDP Growth Base Case / Thesis 2010 GDP: 8.5% Transitioning from policy-driven to private-sector- driven growth in 2010: We expect GDP growth to rise to 8.5% in 2010 compared to 6.7% in 2009. In 2010, even as policymakers gradually withdraw the monetary and fiscal policy support, we expect the growth momentum to be sustained. Sustaining 8% plus growth in 2011: We expect the government to execute on several of the long-pending policy changes, ensuring acceleration in the capex cycle (manufacturing as well as infrastructure) along with steady growth in private consumption.  Bull Case 2010 GDP: 9.0% We see a bull-case scenario growth for India at 9% in 2010, assuming acceleration in pace of structural reforms from the government and better than expected external demand.  Bear Case 2010 GDP: 8.0% We think the key risk to our base case is a decline in global risk appetite and capital inflows in the country. Any spike in commodity prices will stoke inflation pressures and push current account deficit wider to vulnerable level. E = Morgan Stanley Research estimates; Source: CEIC, IMF, Morgan Stanley Research 2009 2010e 2011e 2012e 2013–17e Bull 9.0 9.8 10.3 11.0 Base 6.7 8.5 8.7 9.0 9.5 Bear 8.0 7.7 7.8 7.5 Bull 12.3 7.5 7.0 6.5 Base 10.8 12.0 6.5 5.6 5.0 Bear 10.5 5.8 5.0 4.0 Policy Rates (EOP) 4.75 6.25 7.50 7.75 CAB (% of GDP) -2.2 -3.4 -2.3 -2.0 Fiscal Balance (% of GDP) GDP CPI -9.8 -8.1 -7.3 -6.9 -4% -2% 0% 2% 4% 6% 8% 10% 12% 14% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E 2011E 2012E Brazil Russia India China
  22. 22. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 22 Russia Economics Risk-Reward View Investor Debates  To what extent will the food prices and social transfers accelerate the CPI inflation in 2011?  When will the CBR start the rate hiking cycle?  What will the final privatisation plan and schedule look like? What’s in the price?  Consensus sees GDP growth around 4.0% in 2010, and 4.5% in 2011. We are slightly more optimistic on this year but we see risks of the weakening external demand. Signposts Nov-2010 Final 2011-2013 Budget Law Dec-2010 The final privatisation plan from the government Alina Slyusarchuk, (44) 20 7677-6869, alina.slyusarchuk@morganstanley.com Key Indicators Domestic Demand Takes Over as a Growth Engine Base Case / Thesis 2010 GDP: 4.2% We expect growth to reach 4.2% in 2010. We cut our previous forecast of 5.5% due to lower than expected 1Q GDP growth as well as the slowdown in activity seen in the summer caused by extreme heat. We are positive on 2011 with our GDP forecast at 4.3%, thanks to a boost from investment. Also, the government plans to increase social spending prior to presidential elections in 2012. As a result, we are concerned about upside inflation risks next year, but are also optimistic on household consumption (+5.5%Y in 2011). We expect the CBR to stay on hold until the end of the year, and to start tightening only in 2011, when the recovery is on firmer grounds.  Bull Case 2010 GDP: 5.0% Stronger commodity prices could boost short-term growth.  Bear Case 2010 GDP: 3.5% We see risks of the weakening external demand and more negative contribution from net exports. Hidden bad debt may constrain domestic demand and credit, while an absence of reform may leave growth stagnant. Source: Morgan Stanley Research 2009 2010 2011 2011–2015 GDP Bull -7.9 5.0 6.5 6.0 Base 4.2 4.3 3.7 Bear 3.5 2.2 1.5 CPI Bull 11.7 7.1 10.7 11.0 Base 6.7 9.0 8.1 Bear 6.4 6.8 4.0 Policy Rate Bull 8.75 8.25 12.00 NA Base 7.75 8.50 NA Bear 6.75 6.00 NA -40 -30 -20 -10 0 10 20 30 40 1Q- 01 1Q- 02 1Q- 03 1Q- 04 1Q- 05 1Q- 06 1Q- 07 1Q- 08 1Q- 09 1Q- 10 1Q- 11 Real GDP HH consumption Export Fixed investment Import % year on year MS forecast
  23. 23. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 23 US Rates Risk-Reward View Investor Debates  What will be the size of QE2?  Will QE2 work, if no then what?  Will stimulus arise in the form of a streamlined refi wave?  What will the impact of QE2 be on rate levels and the shape of the yield curve. What’s in the price?  The Fed is priced to be out of the market until late 2011. Thus front-end rates a re priced to be low and stable. The market is also pricing QE2 to be ~$1Tr over the next year. UST 10yr could fall toward 2.25% as a result. Trades • We maintain our longs in front-end forward rates. This strategy that looks to take advantage of roll down and carry has been our core thematic trade. However, we are now looking at longer dated forwards as well, • We like owning the belly of the curve. In particular, we like owning UST 10y vs. 2s and 30s. We want to enter this position upon a back-up in yields. See chart. • In volatility space, we like owning variance swaps. Volatility is low but 10y rates are making many double digit daily moves; variance is a good way to play this. Political uncertainty and economic uncertainty are expected make rates volatile over the coming months. Jim Caron, (212) 761-1905, Jim.Caron@morganstanley.com Catalysts Base Case / Thesis 10y Range: 2.25%-2.85% We are taking a more tactical approach to the market. We see the near-term range for UST 10y to be 2.25% - 2.85%. The exposure in the market is that investors are long USTs. The record pace of inflows into bond funds confirms this. Real money is the main buyer as they were late to the bond market rally. For many, the Fed’s decision to buy USTs was the game changer. Now with the details of the Fed’s QE purchases of $500bn USTs, we believe this may cause the 10y to drop to 2.25% and the UST 2s10s curve to flatten to 175bps. A risk to ‘risk on’ trades is that low rates foster greater demand for higher returns and encourage investors to take on a larger duration exposure than they otherwise would.  Bull Case UST 10y 2.00% If economic data weakens materially and the Fed decides to launch a QE2 program whereby it purchases additional assets, then yields could materially drop.  Bear Case UST 10y 3.25% If the data surprises to the upside and removes the tail risk of a faltering economy, thus the Fed may not engage in QE causing yields to rise materially. Note that investors are long bonds and a liquidation/stop-out trade is a risk. What we're watching Market Inflection Points Flow of Money Bond funds continue to have a record pace of inflows despite the fact that yields continue to fall. As long as the Fed engages in QE and keeps yields low, then there is little risk. But if rates start to rise, then the risk is an exodus from interest rate and spread products. UST 10y Most investors believe that QE will take place at the Nov. 3 FOMC meeting. The expectation is for a sizeable program that drives yields lower toward 2.25% Yield Curve The part of the curve that we expect to perform best is the 5-10yr belly. We believe QE purchases of USTs will be biased toward this sector of the curve as it has the highest sensitivity to mortgage rates. Source: Bloomberg, Morgan Stanley Research Gap Re-Shaping the Curve may be a Key Source of Alpha Gap in T 2s10s Curve & 10s30s to Narrow
  24. 24. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 24 Europe Rates Risk-Reward View Investor Debates  Peripherals: carry vs. potential event risk. Even those with a bearish “end game” view are worried about the risk of underperformance.  If the EUR rallies on QE, what can the ECB do? What’s in the price?  Rates: Decent sell-off in rates ahead of Fed QE announcement. Risk are two-way now but still with very little chance of ECB rate hikes priced for 2011-12  Peripheral CDS implies 5y cumulative probability of default for peripherals as follows (40% recovery): GR 52%, IE 35%, PT 31%, SP 19%, IT 16%. Trades Spreads: Long IT SP FR & BE vs. short PT IE NL Long low coupon vs. high coupon in Greece, Ireland Portugal, Spain, (cheap insurance against contagion) Rates: Duration: back to flat after 35bp sell- off Curve: 5s to underperform on the curve, 10s to outperform Regulatory uncertainty adds volatility to 10/30: buy 5y 10/30 curve caps Laurence Mutkin +44-207-677-4029, laurence.mutkin@morganstanley.com Peripherals still inside last month’s wides - just Catalysts Base Case / Thesis Italy, Spain & France to perform into year-end Three reasons to reverse underweight peripheral vs core: 1. Our tactical trading model has its smallest underweight to peripherals for 5 quarters 2. Changes afoot in regulation of banks & insurance companies may support peripheral bonds 3. For investors measured against a pan-Europe index, the balance of risks of owning peripherals, which was heavily skewed to the downside earlier in the year, is less heavily skewed now. Positioning is, we believe, underweight Spain & France; and carry is positive for both vs important indices. In the past month, spreads have moved in; but not by much.  Bull Case IT, SP tighten 30bp, FR by 10bp For a/cs benchmarked vs. broad EU indices, shorts in weighty peripherals (IT, SP) carry large underperformance risk, due to carry & contribution to index volatility. Same argument applies to France vs. AAA-only index.  Bear Case IT, SP widen 25bp, FR by 15bp Notwithstanding the bullish arguments, peripherals are subject to event risk & sharp swings in sentiment: something of that nature could easily overwhelm the carry cushion of these peripherals. What we're watching Why it matters EUR Trade-weighted EUR is +5% from summer levels. Another 7% would put it @ 2008-09 highs, raising possibility that ECB would have to be more accommodative Peripherals Politics, budgets: with many weak or minority governments in the EU, fiscal backsliding is a risk NL pensions developments A softening of ALM rules would see large steepening in 10/30 swap curve Source: Morgan Stanley Research
  25. 25. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 25 UK Rates Risk-Reward View Investor Debates  August Inflation Report was dove-ish, implying very low rates for very long. But with CPI, RPI well over target: how long can BoE (a) keep rates on hold; (b) maintain credibility? Sterling should be the first place to see erosion of credibility What’s in the price?  Front end has rallied still further with 2s @ ~ funding +15bp: running out of upside here.  Gilts are trading tighter vs. Bunds despite the DBR flight-to- quality, but have further to tighten Trades Long Gilts vs. swaps in 30-years Long Gilts vs. Bunds moved in 10- years & 5-years Maintain long 5s/20s steepener Laurence Mutkin +44-207-677-4029, laurence.mutkin@morganstanley.com Gilts-Bunds can still narrow further Catalysts Base Case / Thesis Weak growth plus fiscal tightening means Gilts should outperform Gilts yields have fallen on election producing fiscally hawkish coalition government, but room to rally further. Gilts/Bunds has narrowed but has further to run, as Gilts are still relatively too cheap & Bunds could cheapen further as flight-to-safety bid unwinds after bank stress tests. We expect ongoing UK 30y ASW buying will support 30y Gilts.  Bull Case Gilts/Bunds narrows ~20bp to ~ +45bp Spread has finally moved in, helped by growing confidence in the UK governing coalition’s sustainability & by Bunds unwinding some of their flight-to-quality bid after the EUR banks stress tests. The spread has further to go before reaching our target. Ongoing ASW buying from UK pension funds and/or cheapening of Bunds on EMU fiscal concerns spreading to core could sharply narrow Gilts/Bunds  Bear Case Gilts/Bunds widens to 100+bp Further EMU flight-to-quality could see Gilts lag What we're watching Why it matters Sterling A weakening in GBP would be a sign that the BoE may be unable to “hold the line” in its dove-ish policy stance Source: Morgan Stanley Research
  26. 26. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 26 EM Fixed Income Risk-Reward View Investor Debates  Currency intervention – how far will it go?  The impact of rising inflation expectations and commodities prices on EM fixed income.  Will the inflows to EM asset markets continue? What’s in the price?  Macro and market dynamics have improved, assisting short- term valuations for EM credit spreads and currencies relative to fair value. Prevailing EM sovereign credit spreads suggest market pricing EM real GDP growth of 5-7%, within the range of our economist forecasts. Trades Long local-currency bonds: Israel, South Africa nominal bonds and Korea linkers Receive MXN 2y TIIE and 2y CLP/Camara TRY 2s5s CCS steepener ZAR and PLN 2s10s flatteners Long TWD 1y5y swaption payer Pay INR 1-2y OIS on dips Long MXN/ZAR Favor high-beta (Central and Eastern European countries, Ukraine, Dubai, Argentina) over low-beta credits Focus on idiosyncratic risks: CIS banks and CIS/Latam oil and gas (O&G) are attractive Gain exposure to EM growth through Argentina warrants and O&G sector Catalysts Base Case / Thesis +220 bps Our macro metrics show incipient signs of stability for macro- fundamental trends – and likely moving from deteriorating to improving. This is the first time since 2Q this year; since that time, EM risk markets have traded sideways to lower. This is an important development. It is likely to pave the way for more sustained EM asset price gains well into 2011. It increases the likelihood of our bull case scenario. EM inflation is likely to rise into 2Q11 and with it EM rates to rise and EM currencies to appreciate. Near-term, currency intervention is likely to intensify as response to the US implicit ‘weak dollar’ policy – and as a result gains more limited, but EM currencies have scope to outperform 1H11 (vs EUR and USD basket) on the back of sustained capital inflows, particularly into 2Q as inflation dynamics intensify.  Bull Case +180 bps Sustained capital inflows, signs of re-acceleration in EM growth and attractive long-term valuations argue for strong and steady gains for EM credit spreads (and currencies) through 1H11. For EM currencies, appreciation provides a means of tightening monetary conditions in the face of rising inflation.  Bear Case +380 bps Periphery Europe concerns may weigh on sentiment but we see no material prospect for contagion absent a seizing of DM funding markets. Signs of EM macro-fundamental improvement may prove to be fleeting, leaving markets with limited upside. What we're watching Why it matters Capital flows Steady and strong flows into EM, so far mostly portfolio equity and fixed income likely to maintain upward pressure on EM asset prices and be met with policy response, which may lead to periods of volatility. Currency policy Post-QE2 announcement and G20 the scope for intervention or capital controls. CNY trade-weighted revaluation likely to mitigate EM central banks weighing against strength in their currencies. Monetary policy Inflation, likely to intensify in early 2011, ultimately requires a degree of policy tightening. Market may be uncomfortable with the prospect of sustained tightening so early in the recovery. EM rates – lower for now, but higher into 2Q11 EM composite 2y IRS – Actual versus MS Model Prediction Rashique Rahman, +44 207 677 7295, rashique.rahman@morganstanley.com Source: Morgan Stanley Research, Bloomberg 4.0 5.0 6.0 7.0 8.0 9.0 10.0 Jun-05 Mar-06 Dec-06 Sep-07 Jun-08 Mar-09 Dec-09 Sep-10 Jun-11 Act Pred
  27. 27. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 27 FX Risk-Reward View Investor Debates  How much QE is already in the price and thus how much will it continue to drive the USD lower.  ECB is normalising policy and ongoing rebalancing flows are likely to keep it the strong G3 currency for now.  Currency tensions remain a theme, despite G20. Modest capital controls continue to creep in pushing G10 higher. What’s in the price?  Forwards discount 1.39 in EUR/USD and 80.3 in USD/JPY by year-end, respectively, compared with MS forecasts for 1.36 and 93. Trades Short EUR/CHF target 1.28 Long EUR/USD target 1.46 Short EUR/SEK target 8.88 Long GBP/JPY target 134.50 Short MS Dollar Index target 65.00 Long MS AxJ Index target 120.00 Stephen Hull, (44) 20 7425-1330, Stephen.Hull@morganstanley.com EUR Rebalancing Demand Catalysts Base Case / Thesis EUR/JPY +5% in 2010 The Fed’s move to QE will continue to weigh on the USD, given the longer term implications for US inflation and the uncertainty of success. It is also clear that US policy makers view USD weakness as part of the solution. Until such time as EM takes on more appreciation, the axis of adjustment is likely to come via the EUR. This is particularly true whilst the ECB continues to see a passive normalisation of policy. We believe there is greater upside before Euro area policy makers will lean against this strength. The JPY should be weaker, from a fundamental point of view, although we may need to see more commitment to easing and an inflation target before this is reflected in the JPY.  Bull Case EUR/JPY +15% in 2010 While the prospect of the Fed implementing more QE is being priced in, implementing this policy in a larger size and if it were open ended may result in greater demand for EUR. Meanwhile, the Japanese follow up their initial intervention with a credible easing policy and much larger, sustained intervention.  Bear Case EUR/JPY -10% in 2010 The changes in the EU Treaty rules and concerns regarding the ability of the periphery to implement fiscal tightening weigh on the EUR. At the same time, the BoJ does not provide credible additional easing. In addition, the biggest surprise would be a concerted effort by EM to allow for meaningful appreciation, this would ease the appreciation pressure on the G10 and EUR in particular. What we're watching Why it matters The Federal Reserve The market has focused on the Fed’s QE but we are waiting for the specific details on the objectives as a guide for the extent of QE, as well as duration of the purchases. Post the meeting, we are monitoring for Fed member’s conviction regarding the effectiveness of the policy. US Inflation Given the increased focus on inflation for the FOMC and the part it is likely to play in driving QE, the inflation data is likely to be more important than usual. The surprise would be for greater than expected readings, strengthening USD. Global Rhetoric on FX While the G20 meeting were committed to addressing imbalances and co- operating in reducing tensions, we have seen more talk of capital controls post the forum. As such, with the USD expected to moderate, we are watching for any further action to counteract capital flows and EM appreciation. Source: Morgan Stanley Research; EPFR, Bloomberg - 6 0 0 0 - 4 0 0 0 - 2 0 0 0 0 2 0 0 0 4 0 0 0 6 0 0 0 8 0 0 0 J a n - 0 4 J a n - 0 5 J a n - 0 6 J a n - 0 7 J a n - 0 8 J a n - 0 9 J a n - 1 0 1 1 . 1 1 . 2 1 . 3 1 . 4 1 . 5 1 . 6 1 . 7 E M T o t a l F lo w ( m n U S D ) E U R U S D S p o t
  28. 28. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 28 DM Equities Risk-Reward View Investor Debates  Strength and sustainability of macro expansion  Significance of policy action on macro cycle and risk assets/resolution of debt super-cycle  Extent of margin uplift/profits from EM expansion What’s in the price?  Sell-side earning forecasts are for sustained earnings expansion: over 30% increase in EPS between 2010 and 2012 (both SPX and MSCI DM), after a sharp gain in 2010  Buy-side arguably more cautious. Equities appear cheap if consensus earning forecasts are correct Trades Regional: Buy EM over DM Sector: Long Europe Exporters Long US/Europe Industrials Thematic: Buy Large Cap Quality Buy EM exposed DM stocks Buy Dividend Yield / Reliable Growth Gerard Minack, (61) 2 9770-1529, Gerard.Minack@morganstanley.com Equity Returns Follow Cycle Lead Catalysts Base Case / Thesis DM: Equities range bound SPX 950-1250 Three reasons to expect range-bound equities: 1) that’s what usually happens after big bear markets; 2) valuations point to low returns; 3) we expect a sub-par macro cycle. So far markets have broadly followed the script. We don’t expect equities to break the range until either the structural problems fade (upside risk) or recession looms (downside). We think the latter is more likely, but not this year. QE2 is the new unknown. While we doubt it will be a macro game-changer, it may help risk assets independently of the impact on macro. We think the risk-reward on equities is becoming less favourable, but QE2 may see more upside.  Bull Case Double-digit gains in 2011 Sustained macro expansion, ongoing low rates, and further gains in margins and a QE2-inspired re-rating of risk assets. Earnings appear likely to meet consensus expectations for new record highs in 2011.  Bear Case Back to lows Sovereign stress takes hold in the G7 and/or double-dip as stimulus is withdrawn. DM markets would likely see a serious deflation scare in this scenario. What we're watching Why it matters Leading indicators In a credit-less cycle, what moves equities is changes in earning expectations. Equities don’t worry about rates, they worry about growth. If growth sentiment worsens, equities will weaken. Margins Margins have surprised us, and we think forecasts for 2011 are too high. If productivity slows, margin forecasts look too high. Sovereign debt Sovereign stress is the sword of Damocles hanging over this expansion. Source: IBES, DataStream EXCESS EQUITY RETURNS AND OECD LEADING INDEX -60 -45 -30 -15 0 15 30 45 60 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 EQUITY-BONDRET6M% -20 -15 -10 -5 0 5 10 15 20 6MSAAR% GLO BA L* O E C D G7 LEI (RHS) * EQUITY LESS BOND RETURN (6 MONTH) MSCI DM LESS ML G7 GOVT BOND INDICES
  29. 29. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 29 European Equities Risk-Reward View Investor Debates  What is the outlook for growth in the global economy and European corporate profits in 2011?  What are the implications of further QE on growth, inflation and asset prices?  With regulations increasingly encouraging institutional investment in bonds who will buy equities in the future? What’s in the price?  MSCI Europe trades on a consensus 12m forward PE of 10.8 compared to a long-run average of 14 and our subjective ‘fair value’ range of 11-12 for this cycle. Europe’s trailing dividend yield is 3.2%, the same as a pan-European government bond. Our CVI suggests an 85% chance of up markets in the next 6 months. Graham Secker, + 44 20 7425-6188, Graham.Secker@morganstanley.com Earnings Growth Leading Indicator (EGLI) Catalysts Base Case / Thesis MSCI Europe: 1270 We are overweight equities as we believe the market is too pessimistic on economic and corporate profit growth, while valuations are reasonable and broad longer-term sentiment is weak. We assume 4%+ global GDP growth in 2011 will translate into double-digit EPS growth again next year. Our base case index target offers 10% upside and hence does not imply any re-rating of European stocks. In our base case we also assume that the European authorities manage to stabilise the outlook for eurozone sovereign debt, with yields moving moderately higher due to a better growth environment.  Bull Case MSCI Europe: 1420 ‘Normal Cycle – albeit with lower growth and lower rates’ (23% upside). Bond yields of 3.5%, short rates at 1.25%, CPI at 2.5% and 20% EPS growth in 2011. Using a CVI value of 0 (fair value) this implies a MSCI Europe target of 1420 and an implied 2011 PE of 13.1.  Bear Case MSCI Europe: 715 ‘Double-Dip’ (38% downside). Bond yields of 2%, 3M rates of 0.75% and headline CPI of 1.25%. EPS falls 20% in 2011. Using a CVI value of -2, this implies a MSCI Europe target of 715 and an implied 20011 PE of 9.8. In this scenario the European Shiller PE would fall to 8.6. What we're watching Why it matters Growth indicators Evidence that the economic recovery is sustainable should provide strong support for stocks. However weakness in lead indicators and job/wage data would raise fears in the market of a double-dip Inflation and net flows into equities Inflation expectations have risen in the US, UK and Europe over the last couple of months. Corroboration of this trend in the real economy will raise pressure on asset allocators to consider switching from nominal to real assets. Corporate newsflow re earnings and M&A Corporate newsflow has held up better than economic newsflow over the last few months with companies’ maintaining confidence in their earnings outlook. With FCF yields at record highs and borrowing costs at record lows we expect to see an acceleration in M&A activity. Source: MSCI, S&P, IFO, OECD, GSCI, Haver, Datastream, Morgan Stanley Research. For details see Upgrading European Earnings - Trough in 3Q09, 20% Growth in 2010, August 17, 2009. -60 -40 -20 0 +20 +40 +60 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 Predicted YoY EPS Growth % Actual YoY EPS Growth % Aug-11e YoY EPS = 44% In-sample forecasts Out-of-Sample forecasts Trades OW equities, UW bonds Sectors: O/W – Insurance, Materials, Energy, Telecoms U/W – Utilities, Cons Disc, Healthcare, Div Fins & Real Estate Themes: 1) Add some beta – e.g. Financials & Commodities. 2) Superior EM growth – Energy and Materials offer better value than Staples and Capital Goods. 3) Reliable growth stocks should be long-term winners, however value stocks should outperform in the short- term if the market rallies. 4) Dividend strategies – we like high and secure dividend yielders; stocks where DY > credit yield; index dividend swaps.
  30. 30. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 30 Japan Equities Risk-Reward View Investor Debates  Will the BoJ ease? Or will Japan acquiesce in yen appreciation?  Domestic or export focus?  Is Japan just a trade, or can there be any longer-term story? What’s in the price?  Potential double-dip in the US and global economies; widespread expectation of early, further material yen strength; suspicion BoJ will be reluctant to ease further; EPS of 60 for Topix Trades Buy domestic demand super-large caps: Large has underperformed small; super-large (Core 30) has underperformed large; within the Core 30 of Topix, domestic demand stocks have underperformed. Sector model recommends : Banks, Non-Bank Financials; Telecoms, Marine Transport Alex Kinmont, (81) 3 5424-5337, Alexander.Kinmont@morganstanleymufg.com Topix Scenarios – Base Case = Back to 2004 Catalysts Base Case / Thesis 2010 yr-end: Topix 1000 The mid-cycle growth scare is passing out of the picture; meanwhile policymakers have begun to creep towards easier settings. We maintain our end-2010 target at 1000. Our bond-stock model continues to favour bonds, suggesting choppy conditions until that changes, but that switch could occur quite soon if current trends are continued. The market trades at book value (2/3 of stocks below book); firms are profitable; earnings have been better than expected for H1 F10 and expectations revised up for H2 F10; earnings look as though they are now settling into roughly 20% annual growth. A 20% rally is possible. Yen weakness may prove elusive, but current strength is still the most likely trigger for further monetary loosening. We look for a stronger market and a stronger yen.  Bull Case 2010 yr-end: Topix 1100 BoJ eases more dramatically and further now that directional shift towards loosening has been achieved; Market gets to longer-run fair value quickly. Financials lead.  Bear Case 2010 yr-end: Topix 800 BoJ does nothing further; fiscal policy tightens as programs roll off; domestic recovery is interrupted and deflation resurgent. EPS rises but is a mild negative surprise vs. high expectations. Defensives lead as global investors “give up on Japan.” Source: Morgan Stanley Research What we're watching Why it matters BoJ Any unexpectedly aggressive additional change in stance will spark a sharp rally, or alternatively, a move away from easing could trigger a sharp correction. Global leading indicators Signs emerging that we are close to another inflection point as the high frequency indicators begin to bottom out. Inflation data Any indication of inflation, from whatever source, would be very positive for equities. 1100 800 829.51 1000 600 800 1000 1200 1400 1600 1800 2000 00 01 02 03 04 05 06 07 08 09 10
  31. 31. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 31 Asia / GEM Equities Risk-Reward View Investor Debates  Can Asia / GEM transition towards sustained domestic demand lend growth offsetting a weak industrialised world recovery and eurozone sovereign issues?  Has monetary policy easing in China in 2009 weakened the banking system and generated an asset price bubble in property and more widely in fixed investment? What’s in the price?  Consensus earnings growth expectations for EM have risen to 38% in 2010 from 30% at the start of the year. This is in- line with our base case forecast made in November 2009. It is at 16% for 2011 currently. MSCI EM is trading at 13.9x on 12m forward PER metric, this leaves the asset class priced slightly above the 20-year average of 12.8x. Trades We reduced our equities OW to 4% from 6% (proxy MXEF) and raised our cash weighting, as well as reduced beta in out stock focus list. Reasons for this call: standard valuations metrics are in-line or slightly above long-run averages; technically overbought market; exceptionally strong fund inflows and concerning macro-economic indicator suggesting higher risk for double dip. We are now overweight Asia and underweight Latin America, a region which tends to underperform during corrective phases of MSCI EM. Our preferred markets are China, Russia, Korea, Malaysia and Czech Republic Our sector overweights are Consumer Discretionary, Financials and Energy. We are underweight Telecoms, Utilities and Healthcare Jonathan Garner, +852 2848 7288, Jonathan.Garner@morganstanley.com MSCI EM Trailing P/Book –Now 9% above Average Catalysts Base Case (55%) MXEF: 1120 (+2%) The headwinds of monetary policy tightening in Asia and parts of Latin America are offset by a second year of global economic and earnings recovery. Global growth remains above 4.0% both this year and next. Commodity prices, firm somewhat from end 2009 levels over the year as a whole. China engineers a successful soft landing in bank lending growth and property prices. There are no major political risk events impeding global trade and the RMB post de-peg revalues steadily versus the US$ to 6.60 by year end. Earnings growth is 40% in USD whilst the year-end 2010 trailing PER ends at 16.0x, in line with the 20-year average.  Bull Case (30%) MXEF: 1650 (+50%) Economic growth is stronger and earnings growth is 50%. Funds flows reach the extreme levels of 2Q and 3Q07, prompting a valuation overshoot to trailing PER of 20.0x by year end (similar to end 2007). The payback would come in 2011.  Bear Case (15%) MXEF: 605 (-45%) An economic double-dip as eurozone sovereign risk issues / other negative catalysts impact consumer and corporate confidence. Earnings recession begins again in late 2010. China fails to achieve a soft landing. Earnings growth is below 15% for the year as a whole with a year end trailing PER of 10.5x (average trough last three cycles). Source: Morgan Stanley Research What we're watching Why it matters Asian inflation Outside of India inflationary pressures are moderating. This is allowing forward PER to re-rate consistent with our base case as it did in 2H 2004. Earnings Our base case of 40% EPS for MXEF would generate a 14% ROE and likely a tenth straight year of superior profitability to MXWO. Funds Flow Dedicated EM equity funds reported positive inflows for 22 consecutive weeks, a record for 2010. EM funds reported cumulative inflows of $56bn for this period. Our bull scenario envisages a euphoric phase as in 2007 whilst to avoid the bear it is important that flows do not reverse on a sustained basis as they did in 2008. 2.1x 0.0x 0.5x 1.0x 1.5x 2.0x 2.5x 3.0x 3.5x 4.0x Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 +1 SD -1 SD L-T Avg -2 SD +2 SD
  32. 32. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 32 China (and Hong Kong) Equities Risk-Reward View Jerry Lou, (852) 2848-6511, Jerry.Lou@morganstanley.com Valuation remains Attractive Catalysts Source: Morgan Stanley Research MSCI China FY1 PE 5 10 15 20 25 30 Oct-97 Oct-99 Oct-01 Oct-03 Oct-05 Oct-07 Oct-09 FY1 PE Average +0.5 std -0.5 std +1 std -1 std Investor Debates  Has China entered into a rate hike and tightening cycle?  Will the property sector double dip and drag everything else down?  Will inflation hit China before it hits the developed markets? What’s in the price?  Skeptical about growth sustainability as China has entered into a rate hike cycle.  Double dip of a policy induced property market.  Improved risk appetite thanks to QE2 demand contraction. Trades Overweight high-beta sectors – banks, properties, insurance, and materials. Underweight transportation, consumers, auto, and technology. Base Case / Thesis We remain bullish on China and Hong Kong equities. Despite the recent market recovery we remain bullish. We think China is moderating growth to a more sustainable mode rather than hard landing after stimulus exit, with greater focus on domestic demand. Property price will turn weaker but volume should recover. Policies will remain supportive amid quantitative easing globally and next rate hike unlikely in the next 6 months. Potential catalysts for market to rerate: 1) the peaking out of CPI YoY comp due to base effect shall ease inflation and tightening concerns; 2) consistent appreciation of the Rmb against the US$ shall attract liquidity inflow to China assets including equities.  Bull Case China policies switch from tightening to loosening. New stimulus packages arrive as decelerating signs surface. China accelerates while global cost of capital remains low. Property transaction volume rebounds sharply.  Bear Case Runaway inflation make regulators tighten aggressively, resulting in pessimistic growth prospects, and more severe asset quality problems in the banking sector. What we're watching Why it matters Inflation risks QE2 has a danger to inflate energy and food price globally, which will force China to tighten prematurely. We are watching oil price closely to manage China tightening risk (oil leads China PPI). Rmb appreciation against the US$ With the de-peg from US$, if Rmb consistently appreciates against the US$ in the coming few months, although slowly, it could attract additional liquidity into China equities.
  33. 33. M O R G A N S T A N L E Y R E S E A R C H Global Debates Playbook November 16, 2010 33 Global Corporate Credit Risk-Reward View Investor Debates  Corporates and financials keep repairing balancing sheets, and liquidity is strong. But is this strong enough to offset unprecedented sovereign volatility?  Will the positives of bank deleveraging (less issuance, better capital) outweigh the negatives (credit contraction).  The “good spread / bad yield” conundrum on corp. bonds. What’s in the price?  IG credit spreads still imply a five-year default rate much worse than any seen since 1980, but HY spreads now no longer compensate for a “worse case” experience (although one much worse than average). Implied credit volatility is at the low end of the YTD range, but the skew remains steep, indicating fears of large tail risks remain. Trades Bullish on credit globally, although US & Asia to Outperform Europe. Strong preference for High Yield over IG credit in the US. Long financials, and extend out the maturity curve. Tier 1 in Europe and Asia remains a core overweight, we believe Basel III is an important catalyst that will support bond calls. Positive basis means more value now lies in CDS. Sell bonds, sell protection, and take out dollar price Quality High Yield remains cheap to Low-Quality IG in the US. Overweight BBs vs. BBBs. Take default risk over spread risk. Shorten in non-financial IG credit. Long mezzanine risk in IG tranches and US CLOs. Short senior/super- senior index tranches vs. Delta To hedge, we prefer buying payer spreads, rather than payers outright, given that the volatility skew in credit options remains highly elevated. Greg Peters, (212) 761-1488, Greg.Peters@morganstanley.com Credit still well off YTD Highs Catalysts Base Case Keep Calm and Carry On Credit valuations remain well supported in a lower growth, lower return world. Choppy economic data keeps the M&A cycle more conservative (and sensible) despite the cheap cost of debt capital. With our economists pushing back their rate hike expectations in both the US and eurozone, liquidity will remain ample for longer. Europe muddles through with weak domestic growth, with a weaker euro and pound helping to cushion the effects of greater fiscal austerity, and sovereign spreads stabilizing at higher levels. US and Asia credit outperform on a better growth and extended liquidity, led by Financials. Expect dispersion of performance by Region (Europe vs. Global), Instrument (cash vs. CDS), and regional revenue exposure.  Bull Case 2003-04 Redux Central banks stay on hold until mid-2011. Cash yields at 0% keep money pouring into the asset class, and the ECB is able to unlock coax European banks to deposit less there and instead by sovereign supply. Similar to 2003-04, companies remain adverse to increasing leverage.  Bear Case Global Double-Dip In Europe, the stress tests become a key missed opportunity to break the cycle of bank & sovereign fears, as weaker growth on the back of a strengthening EUR leads to their revival. In the US, low rates fail to motivate continued asset inflows, and continued disappointing data re-ignites double- dip fears. For Asia, the “importing” of loose monetary policy abroad leads to an over-heating Source: Morgan Stanley Research, Bloomberg, iBoxx What we're watching Why it matters Fund Flows Fixed income markets have seen record flows out of equities, and into bonds, despite the lowest yields in generations. Are these inflows here to stay, or are they just chasing returns? Strong recent performance in Equity markets will also challenge retail investor perceptions Issuance Patterns / Shareholder Friendly Activity Our base case is that the unusually uncertain macro outlook has a silver lining: it is keeping corporates much more conservative than they would otherwise be, given their all-in borrowing costs. Still, the longer this persists, the more comfortable companies may be with the new normal. Expect share buybacks, dividend increases, and LBO activity to pick up, although think 2003/04 (not 2006/07). If corporate thinking changes, we expect the US will lead Europe. Levels: '10 Tights (LH), '10 Wides (RH), and Today 107 6.9% 450 96 $101 94 88 6.9% 382 65 $101 76 156 10.0% 630 140 $92 130 US IG CDS (bp) US HY CDS ($ Px) Euro. IG CDS (bp) Euro. HY CDS (bp) € Tier 1 (YTC, %) Asia IG CDS (bp)
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