September 17, 2012 MORGAN STANLEY RESEARCHEuropean Equity Strategy Europe Morgan Stanley & Co. International plc+The implications of QE for equity investors European Equity Strategy Graham Secker email@example.com +44 (0)207 425 6188We look at prior periods of monetary Commodities have been the bestpolicy intervention to assess the tactical performers post prior Fed interventions European Equity Strategy Teamimplications of QE3 for equity investors. Graham SeckerThe sustainability of this policy-induced rally Ronan Carr, CFAdepends on the economic outlook improving Utilities Matthew Garman, CFAin the next month or two. While prior Fed Telecomms Krupa Patelintervention has often been followed by an Health Care Hanyi Limuptick in economic indicators the evidence is Financialsfar from conclusive. Cons DiscAlthough the circumstances around QE3 are ITsomewhat different to prior Fed interventions, Cons Stapwe may see similar market responses initially Industrials– namely: a higher PE; rising investorsentiment; stronger commodity prices; falling Energybond yields; rising EUR; high beta Materialsoutperformance; rotation from Defensives into -4 -2 0 2 4 6 8Commodity sectors. Median Relative Sector Performance 3M After Fed Bond Purchase / QE Announcements, % Source: MSCI, Datastream, Morgan Stanley ResearchMorgan 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 theobjectivity 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 andtrading securities held by a research analyst account.
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012SummaryPolicy-induced rally is only sustainable if growth outlook improves. Equity markets have closely tracked economic growth indicators in this cycle;however, over the last few months this relationship has started to break down as equities have rallied substantially despite continued weak macro data.Much of this divergence is likely due to investors’ hopes for monetary policy intervention, which has duly been delivered by the Fed and ECB. While thelatter provides scope for a tactical rally, its sustainability depends on an improving economic growth outlook. Prior periods of monetary policyintervention have usually occurred against a backdrop of rising growth indicators – the one time this did not occur (2Q11) saw equity prices fall.The timing of QE3 does not fit the historical precedent... Traditionally the Fed has increased monetary stimulus when equities have been falling,inflation expectations are low and financial conditions are tight. In this regard, the timing of QE3 is quite different as it has occurred after a period ofsharply rising equity prices, (relatively) high inflation expectations and loose financial conditions. For example, MSCI Europe has fallen by a medianreading of 13% in the 3m prior to previous Fed interventions but it is currently up 13% over the last 3m.… however, implications of prior monetary policy intervention could still be important. While we should acknowledge the differentcircumstances around the start of QE3, human nature dictates that investors will still look at the implications of prior periods of monetary intervention forhelp in forming investment decisions today. In this report we highlight these prior implications and the summary is as follows:#1 QE boosts PE but doesn’t impact EPS – Post the five Fed interventions we analysed we found that the median increase in the 12m PE over thenext six months was 16% for US and 28% for Europe. Over the last year we also find that ECB policy is now driving equity valuations higher too. Thereis little evidence that prior monetary intervention has an impact on consensus 12m EPS estimates.#2 QE is often followed by better macro growth data. We are generally sceptical that QE has any lasting impact on real GDP growth; however, thecharts on page 9 do suggest that prior Fed interventions have often been followed by an improvement in indicators such as PMIs, weekly initial claimsand US consumer confidence. It is hard to gauge how much of this is causal and how much is coincidence.#3 QE boosts investor sentiment. Post prior Fed interventions we have consistently seen a quick improvement in investor optimism as measured bya higher AAII index, lower put-call ratio and a lower VIX.#4 QE is bullish for commodity prices. Previous QE programs have been consistently bullish for commodity prices, although we note that gold’s bestperformance usually occurs ahead of the announcement. Brent oil has already risen to $117 – over the last five years MSCI Europe has always fallen inthe 3m and 6m post a price of $125.#5 QE is bearish for bonds, bullish for EUR. The start of previous QE programs has always prompted a sharp rise in core government bond yieldswhile the end of such programs has always been followed by a fall in the same yields. QE is generally bullish for EUR versus USD.#6 QE has few regional implications. Prior QE announcements have not given consistent signals as to the relative performance of European equitiesversus their global peers. 2
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012Summary#7 QE drives rotation into higher beta and (sometimes) value. In 4 of the 5 interventions analysed QE has driven a strong increase in the numberof high beta stocks (i.e. breadth) that outperformed subsequently. Value outperformed growth post QE1 and Operation Twist but not post QE2.#8 QE prompts commodity sectors to outperform; Defensives to underperform. Prior periods of Fed intervention have been the catalyst toprompt a sector rotation out of defensives and into commodities. While Financials outperformed strongly post QE1 in Mar-09, they have generallyunderperformed in the other periods analysed. Note that Financials were the best performers in 3m post LTRO announcement.Implications for our European Model Portfolio. Recently we have been positioning our portfolio for the prospect of a rising PE multiple but wherethere is continued downward pressure on consensus earnings expectations (see our report ‘A lower risk premium but lower EPS too, September 102012’). Consequently we believe our portfolio is already relatively well positioned for this environment as we are OW Insurance, Materials and Utilities.We are UW Consumer Staples, Industrials and Consumer Discretionary.Our European Model Portfolio Benchmark Portfolio Benchmark Portfolio Benchmark PortfolioOVERWEIGHTS Weight (%) OW / UW NEUTRALS Weight (%) OW / UW UNDERWEIGHTS Weight (%) OW / UWInsurance (SXIP) 5.1 +2.0 Banks (SX7P) 9.8 0.0 Cons Discr (Autos SXAP & Media SXMP*) 8.7 -2.0 Munich Re, Prudential, Barclays, HSBC, Swedbank, SES, IHG, Reed, Aegon, Allianz BNP Home Retail, VolkswagenMaterials (Basic Resources SXPP & Div Fin & Real Estate (SXFP & SX86P) 4.3 0.0 Cons Staples (SX3P) 14.7 -2.0Chemicals SX4P) 9.5 +2.0 ING, Unibail Rodamco, UBS Imperial Tobacco, BAT, ABI, Nestle Rio Tinto, Akzo Nobel, Lanxess, African Barrick Gold Energy (SXEP) 11.5 0.0 Industrials (SXNP) 10.9 -2.0 BG, Tullow Oil, Saipem, RD Shell Schneider, AtlantiaUtilities (SX6P) 4.5 +2.0 Ryanair*, AP Moller-Maersk Iberdrola, RWE, Terna Healthcare (SXDP) 12.1 0.0 Sanofi, Roche, Novartis, UCB Technology (SX8P) 2.9 0.0 Dassault Systems, SAP Telecoms (SXKP) 6.1 0.0 BT, Vodafone, Deutsche TelekomNote: *Although the shares of this company remain in the model portfolio, Morgan Stanley & Co. International plc policy precludes the exercise of investment management discretion or the rendering of investmentadvice on the shares at this time by the strategist and/or the Morgan Stanley analyst who follows the shares.**Please note that EADS is not currently included in the Model Portfolio due to applicable Morgan Stanley restrictions.Source: Morgan Stanley Research 3
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012Policy hopes have trumped growth concerns in recent monthsEquity prices have closely tracked economic growth MSCI Europe is pricing in a strong ISM reboundindicators in this cycle. However, over the last few months 1250 62this relationship has started to break down as equities haverallied substantially despite continued weak macro data. 1200 60 1150 MSCI Europe 58Much of this divergence is likely due to investors’ hopes for MSCI Europecentral bank policy intervention which has duly been ISM 1100 56delivered by both the Fed and the ECB. However, for therally to be sustainable we need to see these economic 1050 54indicators start to improve over the next 1-2 months. 1000 52 950 ISM (RHS) 50 900 48 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Source: ISM, Datastream, Morgan Stanley ResearchUS consumer confidence has fallen to 2012 lows – Eurozone economic climate continues to deteriorate – 120 SPX normally tracks this indicator closely 1600 this series tends to correlate with equities and GDP 120 1700 110 1400 1600 EC Economic Sentiment Indicator for Eurozone 100 110 Eurozone Economic Climate 1500 90 1200US Consumer Confidence 1400 80 100 1000 S&P 500 1300 70 90 1200 800 60 1100 50 80 600 1000 40 MSCI Europe - rhs 900 US Consumer Confidence 400 70 30 S&P 500 (RHS) 800 20 200 60 700 Jan-07 Dec-07 Nov-08 Oct-09 Sep-10 Aug-11 Jul-12 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12Source: S&P, Conference Board, Morgan Stanley Research Source: MSCI, Bloomberg, Morgan Stanley Research 4
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012In medium-term, growth is more important for equity price performance than policyThe starting and stopping of previous QE programs has consistently coincided with troughs and peaks in the growth outlook (asmeasured by the ISM) – hence it is debatable as to whether equities went up during these periods because of QE or because thegrowth outlook was improving. Interestingly there has only been one occasion of note (2Q11) where the ISM started to decline whilea QE program was ongoing – over that period MSCI Europe fell 7%. While central bank policy intervention boosts equity valuations, we believe equity price performance is more closely correlated to growth expectations Fed announces Fed announces $600bn purchase in QE2 Flagged further purchase of agency MBS at Jackson QE2 Operation Twist $850bn agency QE1 ends QE2 ends Hole Starts starts 64 MBS and $300bn 1300 USTs (QE1) 60 1200 56 1100 52 MSCI Europe ISM 48 1000 44 900 ISM 40 MSCI Europe 800 36 32 700 Sep 08 Mar 09 Sep 09 Mar 10 Sep 10 Mar 11 Sep 11 Mar 12 Source: MSCI, ISM, Morgan Stanley Research 5
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012The timing of QE3 does not fit the historical precedentAs the charts on this page show, traditionally the Fed has QE vs Financial Conditionsincreased monetary stimulus when equities have been falling, Fed announces Fed announces further $600bn purchase purchase of $850bn agency QE2 Flagged at Jackson QE2 Operation Twistinflation expectations are low and financial conditions are tight. 5 in agency MBS MBS and $300bn USTs Hole Starts starts 4 MS Financial Conditions IndexIn this regard, the timing of QE3 is quite different as it hasoccurred after a period of sharply rising equity prices, (relatively) 3high inflation expectations and loose financial conditions. 2 1Investors could interpret this difference in two ways - either: i) itshows just how determined the Fed is to keep doing everything 0necessary and thus is more likely to increase confidence and has -1greater chance of success in driving a growth rebound.. or ii) thatthe "bang for the buck" will be smaller this time as markets are -2 QE1 ended QE2 endedalready elevated...perhaps concerns on the latter explains why the -3Fed sounded more aggressive this time. Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Source: Bloomberg, Morgan Stanley Research QE vs Inflation expectations QE vs S&P Fed announces Fed announces further QE2 Flagged Fed announces Fed announces further QE2 Flagged $600bn purchase purchase of $850bn agency at Jackson QE2 Operation Twist $600bn purchase in purchase of $850bn agency at Jackson QE2 Operation Twist in agency MBS MBS and $300bn USTs Hole Starts starts agency MBS MBS and $300bn USTs Hole Starts starts 3.0 1500 2.5 1400 US 5yr Breakeven Inflation (%) 2.0 1300 1.5 1200 S&P 500 QE2 ended 1.0 1100 QE2 ended QE1 ended 0.5 1000 QE1 ended 0.0 900 -0.5 800 -1.0 700 -1.5 600 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Source: Bloomberg, Morgan Stanley Research Source: S&P, Morgan Stanley Research 6
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012The Fed’s QE has boosted US PE ratios – as rate cuts used to do in prior cycles…In prior economic cycles the PE ratio of US equities generally rose during periods when the Fed Funds rate was falling.Despite ZIRP, this cycle is actually no different – periods of monetary policy intervention have again driven up the PE ratio for USequities. Post the 5 intervention events we flag in the chart below the median increase in the consensus 12m PE for MSCI USA hasbeen 10% over the next 3 months and 16% over the next 6 months (with a hit ratio of 100%). Policy response has been very effective at lifting the In prior cycles conventional Fed policy stimulus used 12m PE for MSCI USA (albeit temporarily) to prompt P/E expansion too Fed announces Fed announces further purchase of QE2 Flagged 20 35 $600bn purchase in $850bn agency MBS at Jackson QE2 Operation Twist agency M BS and $300bn USTs Hole Starts starts 16 18 30 16 15 14 MSCI US Trailing PE 25 12m PE for MSCI USA US Fed Funds Rate 14 12 10 20 13 8 12 15 QE1 ended 6 11 4 QE2 ended 10 2 10 0 5 Jan-71 Jan-76 Jan-81 Jan-86 Jan-91 Jan-96 Jan-01 Jan-06 Jan-11 9 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Periods of US rate cuts Fed Funds Rate US PE - rhs Source: Datastream, MSCI, IBES, Morgan Stanley Research Source: MSCI, Datastream, Morgan Stanley Research 7
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012… and European policymakers are finally having a similar effectPost the Fed’s last 5 intervention events the average increase in Fed monetary intervention has also helped Europe’sthe consensus 12m PE for MSCI Europe has been 12% over the 12m PE – though not around QE2 Fed announcesnext 3 months and 28% over the next 6 months (with a hit ratio of Fed announces further purchase of $600bn purchase in $850bn agency MBS QE2 Flagged at Jackson QE2 Operation Twist80% and 100% respectively). 14 agency MBS and $300bn USTs Hole Starts starts 13In general, a less aggressive/co-ordinated approach to 12m PE for MSCI Europepolicymaking in Europe has meant that sovereign debt concerns 12have been a key driver of equity valuations (from a negative 11perspective) in this cycle. It is only relatively recently that Europeanmonetary policy is driving a similar re-rating in Europe’s 12m PE 10 QE1 endedratio. 9 QE2 ended 8 7 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Source: MSCI, IBES, Morgan Stanley ResearchIn Europe, less aggressive/co-ordinated policymaking … although the ECB’s more aggressive stance is has meant that sovereign debt concerns have been a now having some impact key driver of equity valuations in this cycle… 11.5 14 0 ECB announces OMT (06/09) Median CDS across European countries - INVERTED 11.0 Draghi bumblebee speech (26/07) 13 Europe Median CDS - rhs - INVERTED 100 10.5 end of LTRO2 MSCI Europe 12m PE MSCI Europe 12m PE 12 200 10.0 11 300 9.5 10 400 MSCI Europe 12m PE 9.0 EU summit (28/06) 9 500 ECB announces LTRO (8/12) 8.5 8 600 8.0 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12 Sep 10 Dec 10 Mar 11 Jun 11 Sep 11 Dec 11 Mar 12 Jun 12 Sep 12 Source: Datastream, MSCI, IBES, Bloomberg, Morgan Stanley Research Source: MSCI, Datastream, Morgan Stanley Research 8
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012Monetary intervention has little impact on EPS (which is determined by growth) European earnings revisions move with global PMIsHistory suggests that Fed monetary intervention has little – an upgrade cycle requires our PMI series to reachdurable impact on the growth outlook in this cycle. Our thesis isthat, in a deleveraging economy, fiscal policy is a more 52-53 (equivalent to ISM c. 55) 25 MSCI Europe FY2 Earnings Revisions Ratio (%) 65.0important driver of economic activity than monetary policy. Global Weighted PMI (RHS) 20 62.5 15 60.0Effectively, while monetary intervention can tactically boost the 10 57.5PE ratio there is little evidence that it impacts the path of EPS. 5 55.0 0 52.5Our global PMI series remains at a weak level of 48.3 – -5 50.0historically we have not seen an EPS upgrade cycle until this -10 47.5indicator has been in the range of 52-53 (this is equivalent to -15 45.0an ISM of around 55). -20 42.5 -25 40.0 -30 37.5 -35 35.0 The link between Fed intervention and consensus 05 06 07 08 09 10 11 12 12m EPS is less obvious… Source: MSCI, Datastream, IBES, Morgan Stanley Research Fed announces further purchase of $850bn agency QE2 Flagged … even if we compare the changing growth rates of $600bn purchase in MBS and $300bn agency MBS USTs at Jackson QE2 Hole Starts Operation Twist starts consensus EPS expectations 110 further purchase of Fed announces $850bn agency QE2 Flagged $600bn purchase in MBS and $300bn at Jackson QE2 Operation TwistConsensus 12m EPS for MSCI USA agency MBS USTs Hole Starts starts 30 100 Consensus 12m EPS growth for MSCI USA 90 20 80 QE2 ended 10 QE1 ended 70 QE2 ended 60 QE1 ended 0 50 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 -10 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12Source: MSCI, Datastream, IBES, Morgan Stanley Research Source: MSCI, Datastream, IBES, Morgan Stanley Research 9
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012The impact of US monetary intervention on macro growth indicators QE has tended to occur around turning points US labour market has tended to improve post QE in Economic Surprise Indices Fed announces Fed announces further $600bn purchase in purchase of $850bn agency QE2 Flagged at Jackson QE2 Operation Fed announces Fed announces further QE2 Flagged agency MBS MBS and $300bn USTs Hole Starts Twist starts $600bn purchase purchase of $850bn agency at Jackson QE2 Operation Twist in agency MBS MBS and $300bn USTs Hole Starts starts 700 US Weekly Initial Claims, Thousands (SA) - 4WA 80 60 650 G10 Economic Surprise Index 40 600 20 550 0 -20 500 QE1 ended -40 450 -60 QE1 ended 400 -80 QE2 ended QE2 ended -100 350 -120 300 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11 Mar-12 Aug-12 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Source: Bloomberg, Morgan Stanley Research Source: Markit, Bloomberg, Morgan Stanley Research There is some evidence that QE has lifted Global PMIs US consumer confidence has generally risen post QE Fed announces Fed announces further QE2 Flagged Fed announces Fed announces further QE2 Flagged $600bn purchase in purchase of $850bn agency at Jackson QE2 Operation Twist $600bn purchase purchase of $850bn agency at Jackson QE2 Operation Twist agency MBS MBS and $300bn USTs Hole Starts starts in agency MBS MBS and $300bn USTs Hole Starts starts 60 100 90 55 US Consumer Confidence 80 Global PMI 70 50 QE1 ended QE2 ended 60 45 50 QE2 ended QE1 ended 40 40 30 35 20 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12Source: Institute of Supply Management, Haver Analytics, Morgan Stanley Research Source: Conference Board, Morgan Stanley ResearchNote: Global PMI = 30% China manufacturing PMI, 20% Euro Area manufacturing PMI, 30% Euro Area services PMI, 10% ISM manufacturing & 10% ISM services. 10
MORGAN STANLEY RESEARCH The implications of QE for equity investors September 17, 2012The impact of US monetary intervention on sentiment AAII Net Bulls has tended to bounce post QE When we look across a number of our preferred sentiment indicators it is Fed announces apparent that QE has historically driven a quick improvement in investor Fed announces further purchase of $600bn $850bn agency QE2 Flagged at purchase in MBS and $300bn Jackson QE2 Operation optimism. agency MBS USTs Hole Starts Twist starts 50 AAII - Net Bullish, % (3 Week average) 40 30 20 10 0 -10 -20 -30 -40 -50 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Fed intervention tends to boost hedge fund net Source: AAII, Morgan Stanley Research exposure Put-call ratio generally falls post QE QE2 Flagged Fed announces at Jackson QE2 Operation Twist Fed announces further purchase of QE2 Hole Starts starts $600bn $850bn agency Flagged at 60 purchase in MBS and $300bn Jackson QE2 Operation agency MBS USTs Hole Starts Twist starts 1.3Hedge Fund Net Exposure, % 50 CBOE Put Call Ratio (3Wk Avg) 1.2 40 1.1 30 1.0 0.9 20 0.8 10 0.7 0 0.6 Oct 09 Mar 10 Aug 10 Jan 11 Jun 11 Nov 11 Apr 12 Sep 12 Jan 08 Jun 08 Nov 08 Apr 09 Sep 09 Feb 10 Jul 10 Dec 10 May 11 Oct 11 Mar 12 Aug 12Source: Morgan Stanley International Prime Brokerage, Morgan Stanley Research Source: CBOE, Morgan Stanley Research 11
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