GLOBAL INVESTMENT COMMITTEE / COMMENTARY OCTOBER 2013
MICHAEL WILSON
Chief Investment Officer
Morgan Stanley Wealth Manage...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH M...
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Morgan stanley onthemarkets

  1. 1. GLOBAL INVESTMENT COMMITTEE / COMMENTARY OCTOBER 2013 MICHAEL WILSON Chief Investment Officer Morgan Stanley Wealth Management Never Mind During the past several months, the main concern of investors has been the timing and speed by which the Federal Reserve would begin to end Quantitative Easing. Ever since May when Fed Chairman Ben Bernanke introduced the idea of “tapering” asset purchases, fixed income and equity markets around the world have encountered price pressure and increased volatility. From a price standpoint, fixed income markets have felt the brunt of the pain, along with certain emerging equity markets—especially those that are most sensitive to global liquidity conditions. When the time arrived to actually begin the tapering process, the Fed surprised markets by deciding to delay it. The official reasons for the delay were vague and focusing on the recent tightening of financial conditions. Given almost all of that tightening was the direct result of the tapering fears, that logic seems a bit circular. No wonder investors are confused about the Fed’s real intentions and what the eventual glide path looks like when the central bank starts to withdraw policy accommodation. In our view, the Fed definitely wanted to get the rise in interest rates under control and, to do that, the members decided to use the element of surprise. The good news is that the Fed was successful in getting short-term interest rates back to where they were in May. The bad news is that it may have spent some valuable market credibility in doing so, and, while longer term yields have recovered, they remain more than one percentage point higher than in May. Nevertheless, the Fed likely achieved an important objective, which was to let some of the air out of the balloon that had obviously built up in fixed income markets. We believe that the global economy continues to heal and rising interest rates are a natural occurrence at this stage of an economic recovery. The mid-cycle correction in risk assets that began in May with higher interest rates is likely to persist for several more months. While the recent rally in fixed income could continue until tapering gets under way, we do not think this is a trade worth playing. Instead, we favor stocks over bonds but expect divergent performance across regions, sectors and companies. Stay underweight benchmark duration within fixed income and use any rally to shorten duration if you have not done so already. Within equities, we favor Japan and Europe given their nascent economic and earnings recoveries. In the US, we prefer growth to value.  TABLE OF CONTENTS 2 If Not Now, When? The Federal Reserve delayed tapering, but it didn’t cancel it. What’s the timetable? 3 Don’t Fear the Taper We believe that US equities can do well without additional Quantitative Easing. 4 Where’s the Bear? The stock market is going up because the bearish case is weak, in our view. 6 Prospects for Health Care and Industrials Health care reform and a step-up in global manufacturing improve the outlook. 8 Delayed Expectations After pricing in tapering, bond investors need to make some adjustments. 10 Is Global Growth a Zero-Sum Game? Developed markets appear to be growing at the expense of emerging markets. 12 Blunting the Impact of a Tax Hike Japan looks for a way to protect the economy from the effects of next year’s increase in the consumption tax. 13 Q&A: After the Bond Market Sell-Off Fixed income manager Jeffrey Gundlach discusses rising rates, fund flows and more. On the Markets
  2. 2. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 2 In Recent Months, Mortgage Applications Have Fallen Sharply Note: Both lines are four-week moving averages of the indexes. Source: Morgan Stanley Research, Mortgage Bankers Association, Bloomberg as of Sept. 13, 2013 160 170 180 190 200 210 220 230 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000 Sep-11 Mar-12 Sep-12 Mar-13 Sep-13 MBA Refi Index (left scale) MBA Purchase Index (right scale) ON THE MARKETS / STRATEGY MATTHEW HORNBACH Head of Interest Rate Strategy Morgan Stanley & Co. or several months, the growing consensus among economists, strategists and investment managers was that the Federal Reserve would start dialing back on its $85 billion a month in bond purchases after the Federal Open Market Committee (FOMC) meeting on Sept. 17 and Sept. 18—but the central bank surprised, if not shocked, markets globally by deciding to delay tapering. The action, or lack thereof, raises important questions: Why did the Fed delay the widely expected start to tapering and when will the Fed begin tapering its bond purchases? Why did the Fed delay tapering? The official statement suggested that the economy was moving in the right direction, but policymakers wanted to wait for more evidence that the progress could be sustained. In particular, the FOMC’s statement said, “A tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labor market.” Did financial conditions actually tighten? We believe most observers would answer in the negative, but we suspect that the tighter financial conditions cited refer to the increases in real interest rates and mortgage rates that have occurred since the June and/or July FOMC meetings. In a postmeeting press conference, Fed Chairman Ben Bernanke said the FOMC was “somewhat concerned” with the rise in rates. He further stated, “We do want to see the effects of higher interest rates on the economy, particularly mortgage rates on housing.” When will the Fed start to taper? Lower real rates and lower mortgage rates have worked with a lag to stabilize and improve the economy and the housing market. Likewise, higher rates should slow the economy with a lag. We believe that the policymakers may have wanted to give the economy more time to digest the recent increases in rates. The next meeting is Oct. 29 and Oct. 30, which seems hardly long enough to gauge the impact of higher rates on the economy. However, between now and then, the Fed gets one more nonfarm payroll report, one more retail sales report and a series of housing market data. The Fed is understandably concerned about housing. In recent months, building permits and new home sales have begun to turn down and applications for new mortgages and refinancing have plunged (see chart). Another factor that may cause the Fed to wait beyond the October meeting is that measures of home-price appreciation such as the S&P/Case- Shiller Index come out with a lag. August data will not come out until Oct. 29 and, while August was the first full month after most of the mortgage rate increases had occurred, the Fed may want to see more data, given uncertain lags. In addition, a much higher percentage of consumers surveyed by the Conference Board expected higher interest rates in June and July than in any month since 2006. Expectations remained high in August as well. The FOMC may want to see if these expectations affected spending Tapering: If Not Now, When? F
  3. 3. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 3 US Economic Data Come Closer to Expectations Source: Bloomberg as of Sept. 18, 2013 -1.0 -0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0 Jan '11 Jul '11 Jan '12 Jul '12 Jan '13 Jul '13 Jan '14 >0 = Economic Data Outperforming Expectations <0 = Economic Data Underperforming Expectations ? ? behavior negatively, or if consumers pulled forward demand for goods that required financing. As a result, Fed officials may want to watch data over the next 12 weeks until the December FOMC meeting. If data remain strong until then, they should feel more comfortable tapering because the economy appears strong enough to handle the recent tightening in financial conditions. By December, the Fed would have seen three nonfarm payroll reports, several more cycles of housing market data and three retail sales reports. Unfortunately, the recent history of the Bloomberg Economic Surprise Index suggests the data could go either way from here (see chart), so the Fed may have to wait a while longer to get a clearer picture. Vincent Reinhart, chief US economist for Morgan Stanley & Co., estimates there is a one-in-five probability that the Fed will begin tapering this month. He keeps the probabilities the same for the December meeting, which implies about a 35% chance of action this year. The US Treasury market may not be able to keep pricing in a high probability of the first taper while waiting the entire six or 12 weeks for all of the data. So, any hint that data might surprise to the downside should give the market enough reason to push back timing of the first tapering.  Don’t Fear the Taper Equities rallied on the Federal Reserve’s Sept. 18 surprise decision not to taper its asset-purchasing Quantitative Easing (QE) program and on the prospects of a more dovish Fed chairman before consolidating on Sept. 20. Our analysis suggests that equities may have been responding to greater confidence in highly accommodative forward rate guidance, rather than the tapering news. We recognize it is a potentially contrarian view but, from our analysis, we do not find evidence that additional QE currently matters for equity markets. Tapering of asset purchases should not pose a significant risk for equities. Settlement dates—when the Fed actually pays brokers for the mortgage-backed securities (MBS) it purchases—mattered for equity market returns, but mainly in the first six months of QE3. By contrast, daily trade amounts were not correlated with equity returns. The impact of settlements has been declining and the effects of the Fed’s MBS purchases appear to have saturated. Since the start of QE3, we estimate the cumulative impact of the Fed’s buying to the S&P 500 at almost 7%; this peak occurred in spring of 2013. Energy, materials and financials had stronger responses to QE, but only in energy was this effect not subsumed by commodity and interest rate moves. Delaying the start of conventional tightening has recently emerged as an effective tool for stimulating equities. There was a shift in the response of equities to changes in Fed funds futures prices: Prior to spring 2013, there was a negative correlation, but it is now positive. Expectations for earlier/faster conventional tightening now have a negative effect on equities. By pushing out its low-rate guidance, the Fed can stimulate equity markets. A strengthening recovery may ultimately limit the Fed’s ability to extend its low-rate guidance, so the market scenario is simple. Good news on the economy is good for markets. Bad news on the economy is bad for markets. Really good news on the economy is bad for markets because of the front end—not the long end—of the yield curve. —Adam S. Parker, PhD, US Equity Strategist, Morgan Stanley & Co.
  4. 4. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 4 ON THE MARKETS / EQUITIES ADAM S. PARKER, PhD Chief US Equity Strategist Morgan Stanley & Co. ack in March, the S&P 500 was about 1,500, and we raised our 2013 forecast to 1,600. Our base-case view then—and now—is low economic growth and modestly improving margins, pitted against expectations for earnings that are too high. The S&P blew through that target in May and, six months later, it trades near 1,700. Early last month, we raised our 12- month target to 1,840. US equities haven’t been climbing higher on the back of surprisingly higher earnings but higher earnings multiples. That means stocks are going up not because there are more earnings but because investors are willing to pay more for every dollar of earnings. Investors are used to optimism about profits from sell-side analysts. Since 1976, the median year-over-year earnings growth forecast in January for the full year ahead is 14%, but expectations on average decline throughout the year to closer to 5% average earnings-per-share (EPS) growth. This is because analysts and company managements start the year optimistically and then adjust their optimism as the year progresses. EARNINGS OPTIMISM. Indeed, the market can work well even as the base case is being revised downward. In fact, in 28 of the 36 years since forward earnings data have been collected, January estimates by bottom-up sell- side analysts proved excessively optimistic. Only in eight years were estimates too low, and in six of those years—2003, 2004, 2005, 2006, 2010 and 2011—the January analyst forecasts turned out to be too low as well. These lowball estimates tended to be in periods of recovery from recessions. As this cycle gets longer and longer, the odds that analysts are being too conservative in their projections shrinks. Still, as we mentioned, we don’t think the issue is that base-case expectations are too optimistic. Rather, we think multiple expansion is likely due to the lower probability of the bear case and, importantly, the lower severity of an earnings fall-off if a slowdown does surface. EMERGING MARKETS CONCERNS. Our Global Economics team is forecasting accelerating GDP in the developed markets and a stabilizing economy in the emerging markets. We don’t see material EPS risk that would increase the chance of the bear case against a backdrop of an improving global economy. True, the emerging markets are a concern and, in our view, they are one of the biggest risks to being too bullish on the S&P 500. If these economies continue to decelerate and don’t stabilize, we acknowledge that there could be risk to the market multiple as fears of a downturn grow. While Fed tapering has dominated much of the conversation since June, we reiterate our stance that, in any case, the Fed will remain extremely accommodative. Tapering, say, to $65 billion from $85 billion per month of purchases is still very far from tightening, and we expect accommodation to reign. In that light, why are we confident that a major cycle top isn’t imminent? Because hubris and debt typically define the top of each market cycle, and we don’t see problems with either. MEASURING HUBRIS. We measure hubris through management confidence and activity. For instance, while the stock market is near its all-time high, the Conference Board’s CEO Business Confidence Survey remains only slightly above average. Many corporate CEOs remain concerned about the sustainability of the recovery, in part given the impact that monetary and fiscal policy has had on boosting the recovery, and wary of future demand for their products. As such, the ratio of capital spending to sales intensity has picked up only slightly from its 2010 low. Most companies simply don’t need to meaningfully increase their capital spending because utilization levels just aren’t that high. This may modestly hurt the magnitude of the US economic acceleration, but it is a good scenario for corporate profitability, as rising utilization without incremental increases in capital spending is quite supportive of profitability. Another sign of management hubris would be a strong inventory build-up. Inventory-to-sales levels have modestly ticked up of late, but we think CEOs are unlikely to be more aggressive and optimistic in the near term. As we analyzed the earnings season of companies in semiconductors, semiconductor capital equipment, contract manufacturing, communications equipment, machinery and other areas, we didn’t read about large backlog extensions, big book-to- bill increases, trouble delivering product in the back-end of the supply chain or other issues of that kind that could surface. Another sign of growing Where’s the Bear? B
  5. 5. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 5 Average P/E Ratios Under Various Real Yields Source: FactSet, Morgan Stanley Research as of Sept. 3, 2013 11.3 13.6 15.1 16.9 18.0 16.7 14.7 13.4 4 6 8 10 12 14 16 18 20 < 0% 0%-1% 1%-2% 2%-3% 3%-4% 4%-5% 5%-6% > 6% Price/EarningsRatio Real Long-Term Treasury Yield Real Long-Term US Treasury Yield Versus Price/Earnings Ratio Since 1930 management hubris would be a substantial increase in mergers and acquisitions. Despite what the headlines suggest, the number of tender offers for large-capitalization stocks is still close to the bottom end of the range. All in all, we don’t see management hubris as having crested. WHAT ABOUT DEBT? Companies’ balance sheets have improved in recent years as they have extended debt maturities. This means few companies are likely to go bankrupt and, hence, the prospects for a relief rally where financially stressed companies get capital and outperform is quite low. At some point, this could be a huge problem for companies if bond yields materially back up in 2016 or 2017 when they look to refinance, but few US equity investors are that anticipatory. So what’s the “right” multiple for the S&P 500? Since 1976, the median price/forward earnings ratio is 13.7. Admittedly, however, the market has rarely traded at that level for any sustained period. Today we are trading 14.5 to15.0 times the next 12 months’ EPS outlook. MULTIPLE FORECASTS. Is that high, low or just right? Forecasting the market multiple is a Sisyphean task, but we believe that growth and interest rates should matter. Look at the 80-year relationship between real yields and the earnings multiple (see chart). Multiple expansion has been coincident with higher real rates recently, though the multiple certainly expanded well in advance of higher real rates, beginning in earnest in June 2012. Ultimately, extreme rates are bad for multiples, so investors must believe that real rates will rise and level out in a benign 2%- to-4% range. In the end then, we are left forecasting continued modest multiple expansion. Our base case is slow EPS growth, culminating in $118 in the second half of 2014 through the first half of 2015. That, coupled with further modest multiple expansion, yields a base-case 12-month forward price target of 1,840. Our bear case is substantially lower EPS and multiples, with a target of 1,352. Our bull case of 2,327 a year from now is global synchronous economic expansion and strong revenue growth for companies, fueling much higher multiples and earnings. FURTHER RISKS. Of course, there are other risks to that forecast. Besides emerging market deterioration, there will be a transition at the top of the Federal Reserve. The Euro Zone’s problems could flare up again, too. Prior concerns over Cyprus, Greece, Portugal, Italy and Spain ended up as buying opportunities because the bear case in corporate earnings did not materialize. To US investors, the biggest risk is a strengthening dollar, as each 1% move in the dollar versus the euro over a full year is a 60-basis-point headwind to corporate profitability. 
  6. 6. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 6 ON THE MARKETS / EQUITIES HERNANDO CORTINA, CFA Senior Equity Strategist Morgan Stanley Wealth Management DAN SKELLY Equity Strategist Morgan Stanley Wealth Management nrollment under the Affordable Care Act (ACA) begins this month, marking a major step in the greatest expansion of health care in the US since Medicare debuted nearly 50 years ago. With this in mind, management teams from health care companies and investors recently gathered at the Morgan Stanley Global Health Care Conference in New York to assess the sector’s prospects. While company-specific factors dominated discussions, the impact of health reform appeared to be ultimately positive—with a long wait and a political wildcard. The backdrop was already positive even before the Sept. 16 program began. The S&P Health Care Index is up 28.8% year to date (as of Sept. 27), the second-best performance among the 10 S&P sectors. Morgan Stanley US Equity Strategist Adam Parker also rates the sector as overweight and his “highest-conviction sector call.” Among the reasons Parker cites are its valuation relative to other defensive sectors, cash on hand, ability to generate free cash flow and the return of capital through a combination of dividend yield and share buybacks (see chart). OPPORTUNITY OUTLOOK. With potentially millions more joining the ranks of the insured, Morgan Stanley analysts participating in the conference saw significant near-term opportunities for pharmacy-benefit managers. Managers from health maintenance organizations (HMO) and hospitals were mixed on their near-term outlook, but saw health care reform as a long-term positive. HMOs said they are taking a cautious, measured approach in their 2014 offerings to the health care exchanges, expecting that it will take a few years for the public to become fully educated on their merits. Facilities companies such as hospitals and diagnostic labs noted that, while utilization trends were down this year, they expect an uptick in 2014 due in part to pent-up demand from the newly insured. DRUG PIPELINES. Among pharmaceutical companies, key themes were drugs in the pipeline, the potential for mergers and acquisitions (M&A), use of cash and tax rates. The most discussed pipelines were in oncology, with several promising drugs on the horizon, as well as new treatments for hepatitis C. Regarding M&A, while large companies are open to acquiring smaller firms with promising new products, most management teams noted that there are few candidates with reasonable valuations. They also discussed spin-offs as a way to enhance value, as well as moving the corporate domicile to lower-tax jurisdictions. In the life-sciences-tools segment, companies that sell to research laboratories noted that sequestration has weakened US academic spending but, with the damage done, sales were not getting worse. More positively, these companies also saw signs of recovery in Europe, and their business outlook for the emerging markets, particularly China, was quite positive. One company noted that it had achieved 20% growth for eight consecutive quarters in China, despite the recent industrial slowdown. Within our Strategic Equity Portfolio (STEP) program, we have highlighted China’s transition to a more consumer-driven economy as a key secular trend, and we continue to favor health care, life-science tools and consumer companies that can take advantage of the trend. INDUSTRIAL INSIGHTS. In contrast with the health care crowd, participants at the Pondering the Prospects of Health Care and Industrials E Health Care Remains a Top Sector for Delivering Total Yield* to Shareholders dium *Dividend yield plus buyback yield. Source: Morgan Stanley Strategy Research as of Aug. 31, 2013 10.0 5.9 5.4 4.6 4.5 4.4 4.4 4.1 4.0 3.9 3.8 0 2 4 6 8 10 12%
  7. 7. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 7 Morgan Stanley Industrials Conference in Laguna Beach, Calif., last month did not have a structural policy change like the ACA at their backs. They did note recent improvement in global Purchasing Manager Indexes (see chart), usually a harbinger of a pickup in manufacturing, but it soon became clear that the benefits of any improvements on that front would be more industry specific and less broad based. Still, the sector’s performance in the stock market has been strong—up 24.7% for the year to date (as of Sept. 27). That performance also raises an important issue, said Nigel Coe, industrials analyst for Morgan Stanley & Co.: Now, with a price/earnings multiple of roughly 15, the sector is no longer cheap. Regionally, many of the management teams spoke of Europe in relatively optimistic terms, such as “bouncing along the bottom” and “seeing signs of life.” That said, few management teams were willing to say how much their European business was improving and several noted that, despite recent improvement, they did not expect a V-shaped recovery. Within North America, managements highlighted continued positive trends through August, particularly in autos. Asia came across as mixed: Water and consumer-product companies seemed to offer the best investment opportunities, while mining- oriented companies were not optimistic about infrastructure-project funding, which would be beneficial for their businesses. AEROSPACE SOARS. Among the most encouraging end-markets, commercial aerospace appears strong across the industry’s segments, driven by increasing flight hours and a resultant increase in demand for spare parts, perhaps the most profitable part of the business. We favor the engine and instrumentation suppliers that can benefit from increasing production and near-record backlogs. Separately, US rail volume reflects modestly improving economic growth and, in particular, grain shipments are expected to rebound in coming months; coal shipments, however, remain weak. Still, we favor the rails given their secular pricing advantage and their efficiency versus other modes of transportation. Residential housing activity seemed to be holding up at high levels supported by a pickup in replacement heating, ventilation and air-conditioning demand. Finally, water treatment companies were said to be well-positioned for growth, particularly in China given the government’s focus on improving environmental and health issues. The outlook was more mixed for defense, which could see further headwinds into 2014 as the impact of sequestration takes hold and the US troop presence in Afghanistan winds down. The commentary on mining companies was negative, as China shifts away from projects requiring significant iron ore, copper and other industrial metals. automakers noted strength in the US and China while Europe remains mixed. Still, some European automakers are discussing boosting production to meet higher export demand.  Rising Purchasing Managers Indexes Bode Well for the Industrials Sector dium Source: Bloomberg as of Aug. 31, 2013
  8. 8. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 8 We Now Have One of the Steepest Yield Curves in History Source: Bloomberg, The Yield Book as of Sept. 20, 2013 0 5 10 15 20 25 -300 -200 -100 0 100 200 300 400 Flattening Yield Curve Steepening Yield Curve Spread Between 10-Year and Two-Year US Treasury Yield (basis points, left scale) Federal Funds Target Rate (percent, right scale) Fed Tightening Cycles ON THE MARKETS / FIXED INCOME KEVIN FLANAGAN Chief Fixed Income Strategist Morgan Stanley Wealth Management JOHN DILLON Chief Municipal Bond Strategist Morgan Stanley Wealth Management JONATHAN MACKAY Senior Fixed Income Strategist Morgan Stanley Wealth Management xpected to announce the start of tapering after its meeting last month, the Federal Reserve surprised the market by doing nothing. The outcome was more dovish than expected, but we believe this is exactly what the Fed intended. In delaying the beginning of the end for Quantitative Easing (QE), it appears as if policymakers finally succeeded in pushing back market expectations for the timing of the first federal funds rate hike. Prior to the most recent jobs report, fed funds futures were priced for the first increase to occur no later than December 2014. That date has now been pushed back to June 2015, about the same time that the market anticipated prior to the Fed’s attempt at forward rate guidance earlier this year. The knee-jerk reaction to the Fed’s lack of action pushed the yield on the 10-year US Treasury down to 2.68%, only one basis point removed from the Morgan Stanley Wealth Management Technical Analysis Group’s first level of support. The uncertainty created by the Fed has increased the potential for more rate volatility in the weeks ahead as the market must now interpret upcoming data through the prism of tapering prospects. However, we do not believe that the 10-year Treasury is on the verge of making new lows, and we maintain the bottom of our 2.50%-to-3.25% range. CLOSE CALL. When the Federal Open Market Committee (FOMC)—the Fed’s policymaking body—will start tapering depends on the economy’s performance. Committee member James Bullard, president of the Federal Reserve Bank of St. Louis, said that the no-taper call “was a borderline decision” and that, based upon upcoming data, the FOMC could be “comfortable with a small taper in October.” While it has become more of a close call, we still think the tapering will start before the end of the year. Whenever tapering begins, it will do so Delayed Expectations Rock the Bond Market E
  9. 9. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 9 Incremental Yield Highest in Four-to-Nine- Year Range Source: MMD Thomson Reuters as of Sept. 24, 2013 0 5 10 15 20 25 30 35 40 45 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Maturity (year) Recommended Maturities Change in Incremental Yield by Extending to the Next Maturity (basis points) *Duration, the most commonly used measure of bond risk, quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the bond or portfolio would be to changes in interest rates. Generally, if interest rates rise, bond prices fall and vice versa. Longer-term bonds carry a longer or higher duration than shorter-term bonds; as such, they would be affected by changing interest rates for a greater period of time if interest rates were to increase. Consequently, the price of a long-term bond would drop significantly as compared to the price of a short-term bond. when the yield curve is one of the steepest in history (see chart, page 8). The steepening, the difference between the longer maturity yields and the short maturity yields, has been going on since early 2007 when the Fed started cutting interest rates. Short maturities are tied to the fed funds rate and longer maturities take their cues from economic data and investors’ risk appetites. Yet, at some point the curve will begin to flatten—the yields will begin to converge—most likely because short-term interest rates rise at a faster pace than long-term rates. FLATTER EXPECTATIONS. Historically, the yield curve starts to flatten in advance of a Fed tightening cycle. These periods are known as “bear flatteners,” which means all interest rates are rising but short rates are rising much faster than long rates. In the 1992-to-1994 and 2003-to-2006 flattening cycles, short rates rose much more than long rates. In contrast, the 2011- to-2012 cycle was a “bull flattener”—rates dropped all along the curve, just much more dramatically on the long end. While we expect the yield curve to remain steep in the near term, at some point the Fed will start tapering and as Morgan Stanley Wealth Management Chief Investment Officer Mike Wilson has said, this could be the equivalent of the first federal funds rate hike. Thus, we may start to see a flattening of the yield curve well in advance of the actual first rate hike, which the market is now anticipating in mid 2015. So what impact does a flattening yield curve have on credit? For starters, longer maturities outperform shorter maturities. Looking at the three most recent flattening cycles, returns were fairly robust for seven-to-10-year maturities even as rates climbed. We would be wary of expecting similar performance this time around, as the starting point for yields is much lower today than it was back in the 1992-to-1994 and 2003-to-2006 cycles, and the 2011-to- 2012 cycle was a bull flattener. SHORTEN UP MUNICIPALS. In light of the recent significant upward rate drift, the current rally and the prospect of further rate-driven municipal market volatility, we encourage investors to utilize periods of market strength, like the current one, to shorten duration*. In addition, considering year-to-date losses in the muni market and gains in equities, we expect an early start to the tax-loss swap season, which is also an opportunity to mitigate credit and interest rate risk. We recently shortened and tightened our own target maturity range to four to nine years from five to 11 years for new- money purchases. This range captures the steepest part of the yield curve, while mitigating potential rate-driven volatility. It is also the zone where investors capture significant incremental yield by extending a maturity one more year (see chart). For example, going from a four-year maturity to a five-year maturity, an investor can pick up 38 basis points; in contrast, moving from a nine-year maturity to a 10- year maturity offers only 17 additional basis points, and the very longest maturities yield only a few basis points for each additional year. With new purchases, we recommend above-market coupons of 5% or more, as higher-coupon securities typically experience less price volatility than those with below-market coupons. CONSTRUCTIVE ON CREDIT. We remain constructive on credit. Despite investor focus in recent months on the credit challenges facing high-profile issuers such as Detroit and Puerto Rico, we believe credit quality continues to improve in the broader market. It is worth noting that Moody’s recently changed its outlook for the US state sector to “stable” after five years of “negative” outlooks. Furthermore, US housing prices, according to the S&P/Case-Shiller Home Price Index, have risen for 17 consecutive months, which is promising for local governments that derive their revenues largely from property taxes. Accordingly, we advocate mid-tier A-rated and higher general-obligation paper, mid-BBB-and- higher essential-service revenue bonds and, when they are attractive on a relative- value basis, prerefunded securities. 
  10. 10. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 10 ON THE MARKETS / ECONOMICS MANOJ PRADHAN Economist Morgan Stanley & Co. or quite some time, the global recovery hasn’t been uniformly positive, a trend we believe is systematic rather than idiosyncratic. That means global growth is slowly becoming more of a zero-sum game, driving us to ask: Why is growth in the US, Euro Zone and Japan likely to come at the expense of growth in the emerging markets? Does this help explain why rising real interest rates in the US have adversely affected emerging market (EM) economies? While zero-sum growth is clearly not good news, is there any reason to believe that the ultimate result is good? Right now, the US is more likely a competitor than a consumer for the emerging markets. The combination of cheap shale energy, a decade of real US dollar depreciation and strong US companies means that the relatively low-sophistication goods that have been unprofitable to produce in the US for a decade are likely to make a comeback. Some already have; fabricated metals, chemicals, cars and construction equipment that supports shale production have all been steady performers in the US economy. However, those same goods represent a step-up in terms of sophistication for most EM economies—a step-up that EM economies need in order to keep growing at a faster pace than the developed economies. So, if the US is moving down the sophistication ladder, EM economies that need to move up will find themselves in direct competition with the US. Growth in the US hampers EM growth. Rising real interest rates and a stronger US dollar are “endogenous”; that is, rooted in better US growth. In the past, better US growth has usually meant better external demand and hence improved current accounts for EM countries. Under those familiar circumstances, a stronger US dollar actually helps EM exports, and higher US real rates don’t create as much of an issue. In the past few months, however, there has been little improvement in external demand for EM goods and hence in EM current accounts—even though developed market (DM) growth was improving. As a result, EM economies saw only the downside from funding pressures thanks to higher US real rates and a stronger US dollar, and they experienced no upside from better external demand and improving current accounts. In other words, the EM-DM growth divide is the reason higher US real rates and a stronger dollar have had such a devastating impact on vulnerable EM economies. US capital expenditures could reinforce the divide. Capex-led import demand from the US does not benefit the emerging markets but rather Germany and Japan and, to some degree, South Korea and Taiwan. Idiosyncratic EM sectors such as information technology services in India or aerospace and defense in Brazil could benefit, but EM as a whole is not in a position to take advantage of a boom in US capital spending. To illustrate, suppose capex accounts for 55 cents of every dollar of growth in the US, while consumption accounts for the other 45 cents. EM economies would see higher external demand thanks to import demand generated by the 45 cents of consumption growth, but they would also face real interest rates that price in the full dollar of increase in US growth. Our US Economics team expects capital Is Global Growth Becoming a Zero-Sum Game? F European Current Accounts Show Improvement dium Source: FactSet, Morgan Stanley & Co. Research as of June 30, 2013 -10 -5 0 5 10 15 Current Account as a Percentage of GDP Euro Zone Germany Spain
  11. 11. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 11 EM Winners, Losers From US Reindustrialization Potential Losers Brazil, Chile, China, Korea, Malaysia Russia, Taiwan Neutral Czech Republic, Colombia, Hungary, India, Indonesia, Peru, Poland, South Africa, Thailand, Turkey Potential Winners Mexico Source: Morgan Stanley Economics as of Sept. 27, 2013 spending to expand by 2.25% this year and by 6.0% in 2014 and 2015. If this forecast is realized, the US could be on its way to sustainable economic growth. EM economies, however, could see more pressure as a result of higher US real rates and US dollar strength without a commensurate improvement in the current account due to strong export growth. Unless EM policymakers deliver on structural reforms, US growth could thus mean downside risks to EM growth (see table). Europe is part of the zero-sum story, too. Through the most unbalanced period of growth in the Euro Zone, its current account— exports less imports, net income from abroad and net current transfers—was balanced. Rather ironically, it is only as the periphery has seen its imbalances fall one-by-one that the Euro Zone’s current account appears collectively unbalanced. The overall improvement in the Euro Zone current account surplus has surged only after the sudden stop has eliminated current account deficits in the periphery (see chart, page 10). This means that the net market share of the Euro Zone is now higher vis-à-vis the rest of the world. Why? Because Germany’s steady current account surplus implies a steady market share, while falling current account deficits in the periphery lower imports due to weak growth and rising exports due to improvements in unit labor costs. The Euro Zone’s current account surplus, if sustained, suggests a greater presence in export markets while stifling imports from other economies into Europe. Japan’s ultimate objective is reindustrialization. To support its demographics, its economy and its asset prices, we believe that Japan must deliver on what Japanese Prime Minister Shinzo Abe calls “third arrow” policies in order to achieve the rising productivity it seeks (see “‘Third Arrow’ Points to Japan’s Future,” On the Markets, May 2013). The first two arrows, a weaker yen and negative real interest rates, are already in place. The third arrow is the broad swath of microreforms that will be needed to encourage manufacturers to produce more at home and export less of the capital that has supported growth outside Japan for more than two decades. In turn, more domestic manufacturing will be able to raise productivity both directly in the manufacturing sector and indirectly in services by absorbing more of the surplus labor that is entrenched in that sector. Structural change in Japan, if it happens, could lead to a more US-style reindustrialization, in turn leading to smaller capital outflows, which have supported growth in other economies. In the long run, what is now becoming a zero-sum game should be a win-win situation for everyone, in our view. Why? How could it be anything else if there is more competition involving the most technologically advanced economies and emerging markets can only compete by removing structural impediments to growth? Both trends will ultimately lead to higher productivity and therefore stronger income growth. That’s still a long way off, but good news nevertheless. 
  12. 12. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 12 ON THE MARKETS / ECONOMICS ROBERT ALAN FELDMAN, PhD Chief Economist for Japan Morgan Stanley MUFG Securities ust a few weeks ago, Japanese Prime Minister Shinzo Abe told his ministers to come up with measures to offset the expected negative economic impact of a hike in the consumption tax. Since the three-percentage-point increase, set to go into effect in April, would be about ¥6 trillion (about 1.3% of GDP), the offset is expected to be about ¥5 trillion in total demand impact. Now, the raging debate is about how to create that demand. This debate is essentially a clash of economic philosophies. A large share of the ruling party favors tax-and-spend Big Government policies, an approach backed by new legislators who want to show concrete evidence of the impact on their districts. In contrast, Abe and his advisors are more in the Small Government camp and see cutting corporate tax rates as a way to spur employment and economic growth. The final result will no doubt be a political compromise. However, the details of this compromise matter for financial markets—especially the details on taxes. REDUCING DIVIDEND TAXES. One approach to tax cutting is to reduce or abolish the double taxation of dividends. In Japan, as in the US and some other countries, dividends are paid from after-tax income. Thus, when dividends are received by individuals, the same earnings are taxed again as individual income. Currently, the national dividend tax is 7.147% of the amount received, and local governments take another 3.0%. Starting Jan. 1, 2014, the dividend taxes rise to 15.315% and 5.0%, respectively. In addition to the dividend tax, there’s the 38.5% statutory tax rate. Two ideas now being floated would end this double taxation. One is to exempt the dividend income from extra taxation; thus, the effective tax rate on corporate profits would be 38.5%, and set to fall to 35.0% rather than 44.7% this year and 51.0% starting in the second quarter of 2014. Alternatively, distributed earnings could be exempted from the corporate income tax, and these earnings would be taxed at the individual level; the net tax take to the government would thus depend on a company’s payout ratio, the tax rate on retained corporate earnings and the tax rate on dividends received by individuals. LOWERING CORPORATE TAXES. The argument for lower corporate taxes is simple: Lower rates spur innovation, investment and employment. Because of the taxes, Japan’s ratio of after-tax profits to pretax profits is 52%, the lowest ratio of after-tax profits to pretax profits of any major region in global equities (see chart). However, if firms do not use the tax savings for wages, dividends or investments, the metabolism of the economy suffers. Therefore, it makes sense for the tax system to encourage higher payouts, and thus to allow individuals and the capital markets to reallocate capital. We believe that the Japanese stock market would react positively either to an outright corporate tax rate cut or measures to reduce the double taxation of dividends, which would incentivize companies to increase payouts. Either of these measures or some combination, we believe, would have a favorable impact on return on equity, and the equity market multiple would therefore likely increase.  Japan Debates How to Offset Consumer Tax Hike J Of the Major Economies, Japan Has Lowest After-Tax to Before-Tax Margin Ratio dium Note: Calculations are based on MSCI indexes, excluding the financial sector. Source: MSCI, Worldscope, Morgan Stanley Research as of Sept. 16, 2013 74 74 69 62 52 0 10 20 30 40 50 60 70 80 90 100 Emerging Markets US Developed Markets Europe Japan %
  13. 13. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 13 ON THE MARKETS / Q&A he specter of ending Quantitative Easing (QE) has caused interest rates and market volatility to jump— even though the Fed has yet to make a move. Jeffrey Gundlach, CEO and chief investment officer of DoubleLine Capital, in an interview with Morgan Stanley Wealth Management Chief Investment Officer Mike Wilson, talks about rising interest rates, fund-flow reversals and how the Fed’s “mishandling” of policy earlier this year set off a liquidation cycle in the bond market. The following is an edited version of their Sept. 11 conversation. MIKE WILSON (MW): The consensus is that interest rates have risen for two reasons: a higher risk premium for the Fed's proposed exit from Quantitative Easing (QE), and higher growth expectations. How much would you attribute to those factors, and what other factors have had equal or even more influence? JEFFREY GUNDLACH (JG): I don't think the rise in interest rates has had much, if anything, to do with higher growth expectations; it's had a lot to do with the higher premium and higher volatility associated with the Fed's proposed exit from QE. Another big variable is reversal of fund flows. The Fed told investors they could rely on QE for a longer period of time than I think they were actually committed to. Investors were experiencing low volatility in all fixed income markets based on this Fed pledge. When it started to soften up in the earlier part of this year, rates began to rise. Once the Fed said it was going to be reducing QE sometime this year, it triggered a classic liquidation cycle. The fixed income sector had a historic level of inflows in mutual funds and other areas like exchange- traded funds, starting from the “QE Infinity” inception in the fourth quarter of 2011. I think many of those investors, once they went to a loss position on what were some late entrants' investments into fixed income, started to move funds out of the sector. It’s been plaguing the fixed income market ever since. Yields have risen on 10-year US Treasuries, with very little countertrend rally, because the flows have been so powerful—and it's typical for late entrants into market cycles to move out very quickly once they move to a loss position. I think that's a large factor in keeping interest rates from reversing to the downside so far. MW: You recently said you thought the liquidation cycle ended June 24. Was that the worst of it? Did people appropriately adjust their risk positions to where they're not going to be forced to liquidate? JG: I think the worst of the problem liquidation is over. The market is trading relatively heavy but showing signs that momentum toward higher yields is slowing. Sectors that did badly during that cycle are still higher than their lowest prices, unlike US Treasuries, which led to higher yields. The sentiment in the bond market is incredibly bad, and that doesn't necessarily guarantee a bottom, but it does corroborate with slower momentum to higher yields. While better, the three-month job gain is actually lower than the 12- month average for the past three months. So together with the fact that the risk sectors that dropped the most during the May-June cycle appear to have double-bottomed, it looks like things are in a position to start rallying a bit. A contrary view I have is that we will start to see inflows back into the bond market late in 2013, once we wring out the weak hands that entered based on the promise of QE and we’ve gotten to a better value proposition. More stable price performance over time should calm investors' nerves. MW: Where do you see the best value right now? JG: We’ve been using dollar- denominated emerging market debt, mostly because the currencies suffered a lot during this period. We're encouraged by the action, and I love the FX (foreign exchange) markets. There's a remarkably tight correlation—it almost works on a day-to-day basis— between the movements in the Treasury bond yield, the long end of the Treasury curve in the US and the FX trends in some of the weaker current account countries like India and Indonesia. Also, emerging market equity markets have shown resiliency. Emerging markets fell mostly for reasons of capital flows, and those seem likely to stabilize. I like some of the muni markets. In general-obligation bonds, you have to go to the long end, but they have good yields relative to taxable Treasuries. That should be a beneficiary of a calmer attitude toward duration and Life (and Markets) After the Bond Sell-Off T
  14. 14. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 14 interest rate risk that I anticipate will happen broadly in fixed income. MW: Where do you think the 10-year Treasury yield is going by year end, and over the next 12 months? JG: I think the 10-year is going to top out at 3.10% or 3.15%—based on the momentum and the basic lack of inflation indicators. All these things suggest that what happened in the interest rate market has a lot to do with the mishandling of Fed policy this year and QE, and with the naive flows into fixed income being reversed. I don't think you're going to see interest rates much higher in the next 12 months. The 10-year Treasury, maybe with bumps in the road, with perhaps overly aggressive reduction of QE as a potential catalyst, could head down to 2.25%. MW: Are we in a vicious cycle of artificially high rates driven by factors outside what would drive rates in a normal economy without that intervention? JG: Where we are relative to profits and wages might change as we move forward a few quarters. There hasn't been much on the revenue side, but there's been improvement on the earnings side, leading to record corporate profitability versus GDP, right next to record-low wages versus GDP. One way you get better profits without much revenue growth is refinancing your debt at lower rates— but, with rates higher now, that game is over. While wages are not growing much, the average hourly earnings data that comes out with the monthly nonfarm payroll report has started to show an uptrend. The rates on Treasuries were intended to be artificially lowered by QE, and for a while they were. People often think Treasuries should approximate nominal GDP growth over the long term. If you take GDP growth of sub-2%—where we've been—throw inflation on it, the rates should have been higher than where they were manipulated down to. I think the Fed wanted rates to be artificially low. QE also greatly reduced volatility. The observed volatility of interest rates in all bond market sectors during 2011 and 2012 was about half of what it normally would have been. With the sell-off in bonds earlier this year, volatility spiked higher, but it's really just reverted to a more normal level. MW: Risk-adjusted returns in the bond market have been spectacular for the last three or four years. Do you think that had an impact on a lot of funds recently—that they had to liquidate because they were holding more volatility in their portfolio, forgetting about where the levels were? Does that mean they can't come back with the same amount of leverage, even if things slow down, because that volatility is going to remain permanently higher? JG: I think so. Also, if funds are leveraged, their ability to get leverage could be under pressure due to regulatory changes. Bond market liquidity is likely to remain in the wrong direction for leveraged portfolios because of the shrinkage of balance sheets in the banking community [and] in the broker-dealer community, and shortages of high- quality collateral. During the bond sell- off, there was a period of poor liquidity, where the bid was disappearing and the bid-ask was getting wider. That makes life harder for leveraged investors. When you get away from leveraged funds, I think a lot of naïve investors were attracted to bonds—people who don’t know how to calculate Sharpe ratios and standard deviations but who look at their statement and see a reliable rate of return without a lot of volatility. But that was because the volatility was low and the rate level at which these investments were being made was not all that rewarding. Some of these investors have started to realize there could be a negative return, not as high of a risk-adjusted return and not even a positive absolute return. Some of that flow has to be reversed. I think it'll take a few months for investors to get over the shifting mindset the market has dealt them. Just like earlier this year when the gold market dropped by $100 in one day, several months later, the trauma had faded enough for people to approach that market more objectively. MW: Could we be surprised with things going up more quickly, like in 2010 where the yield on the 10-year Treasury nearly hit 4%? JG: Anything's possible, but I don’t think we’re going to make a quick move to 4% on the 10-year. It becomes very competitive concerning what that would mean for other fixed income markets. If the 10-year Treasury pushes up toward 4%, I think you'd have a crisis in parts of the emerging markets. I think interest rates matter. I've been in this business 30 years, and when they rise, you always hear “This time it's different,” or, “They haven't risen enough to matter.” Every time the yield curve inverts—not the issue today but it has been in the past—you hear, “It doesn't matter this time.” Subprime delinquencies don't matter. Interest rate rises don't matter. Well, they do matter—a lot. Many believe the housing market wouldn't have any problem if the 10- year went to 4%. I disagree. I think mortgage rates would more than double, with all kinds of negative economic consequences. It's possible, particularly if policy is mishandled, that we could spike—but I don't think it will happen by year end, and probably not in the first half of 2014 either.  Jeffrey Gundlach is not an employee of Morgan Stanley Wealth Management. Opinions expressed by him are solely his own and may not necessarily reflect those of Morgan Stanley Wealth Management or its affiliates.
  15. 15. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 15 Global Investment Committee Tactical Asset Allocation The Global Investment Committee provides guidance on asset allocation decisions through its various model portfolios. The eight models below are recommended for investors with up to $25 million in investable assets. They are based on an increasing scale of risk (expected volatility) and expected return. Hedged strategies include hedge funds and managed futures. MODEL 1 MODEL 2 MODEL 3 MODEL 4 MODEL 5 MODEL 6 AGGRESSIVE MODEL 7 MODEL 8 57% Investment Grade Fixed Income 30% Cash 5% Emerging Markets Fixed Income 1% Inflation- Linked Securities 7% High Yield 5% Emerging Markets Equity 42% Investment Grade Fixed Income 12% International Equity 8% US Equity 15% Cash 1% Managed Futures 5% Hedged Strategies 4% High Yield 2% REITs 3% Diversified Commodities 3% Emerging Markets Fixed Income 8% Emerging Markets Equity 15% International Equity 12% US Equity 10% Cash 2% Managed Futures 7% Hedged Strategies 5% Diversified Commodities 3% High Yield 2% REITs 3% Emerging Markets Fixed Income 10% Emerging Markets Equity 19% International Equity 15% US Equity 6% Cash 2% Managed Futures 9% Hedged Strategies 6% Diversified Commodities 3% REITs 2% Emerging Markets Fixed Income 2% High Yield 13% Emerging Markets Equity 23% International Equity 18% US Equity 3% REITs 1% Emerging Markets Fixed Income 1% High Yield 2% Managed Futures 10% Hedged Strategies 7% Diversified Commodities 5% Cash 4% Cash 22% US Equity 28% International Equity 14% Emerging Markets Equity 26% Investment Grade Fixed Income 17% Investment Grade Fixed Income 7% Investment Grade Fixed Income 1% Emerging Markets Fixed Income 3% REITs 2% Managed Futures 11% Hedged Strategies 8% Diversified Commodities 3% Cash 26% US Equity 31% International Equity15% Emerging Markets Equity 3% REITs 8% Diversified Commodities 11% Hedged Strategies 3% Managed Futures 3% Cash 3% Managed Futures11% Hedged Strategies 8% Diversified Commodities 3% REITs 20% US Equity 34% International Equity18% Emerging Markets Equity CASH GLOBAL FIXED INCOME GLOBAL EQUITIES ALTERNATIVE INVESTMENTS KEY MODERATE CONSERVATIVE MODERATE>>> >>> >>> >>> >>> 33% Investment Grade Fixed Income
  16. 16. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 16 Tactical Asset Allocation Reasoning Global Equities Relative Weight Within Equities US Underweight We are slightly underweight US equities as we believe other developed equity markets will outperform the US given their more nascent economic and earnings recoveries. Should US markets correct 10% due to the debt-ceiling debate or other concerns, we would likely increase our exposure. International Equities (Developed Markets) Overweight We increased our exposure to Japan and Europe in March and in September. Meaningful political change has taken place in Japan, providing a strong tailwind to equity prices. Growth is improving in Europe, which should lead to accelerating earnings growth and better stock performance. Emerging Markets Equal Weight Emerging markets have been disappointing this year. Policy remains too tight in major countries, both voluntarily (China) and involuntarily (India and Brazil). Structural challenges will likely keep policy tight in others. As a result, performance remains quite divergent, offering opportunities for managers to add value. Global Fixed Income Relative Weight Within Fixed Income US Investment Grade Overweight We recommend shorter-duration (maturities) given potential capital losses associated with the current low rates. Yields have risen recently, but not enough for us to change strategy. Within investment grade we prefer BBB-rated corporates and A-rated municipals over US Treasuries. International Investment Grade Equal Weight Yields are low globally so not much additional value accrues to owning international bonds beyond some diversification benefit. Inflation-Linked Securities Underweight We have been underweight inflation-linked bonds since March given negative real yields across all maturities. Recently, these yields have turned modestly positive, but still don’t offer enough compensation. High Yield Underweight Yields remain near record lows but have improved. Opportunity has arisen given the indiscriminate selling in May and June. Investors should begin to wade back in selectively to high yield credits via active managers or single issues. Emerging Market Bonds Equal Weight We reduced our weighting to equal weight from overweight in March due to record-low spreads and yields. Despite the sharp correction since then, we counsel patience given our view for higher interest rates globally. Alternative Investments Relative Weight Within Alternative Investments REITs Equal Weight Rising interest rates explain most of the recent sharp correction. At current levels, we believe REITs are fairly valued and offer select opportunities. Focus on the industrial and commercial segments, which tend to outperform at this stage of the recovery. Commodities Equal Weight Commodities performed poorly in the second quarter as real interest rates rose; China followed tight monetary and fiscal policies; and the US dollar strengthened. Recently, sentiment has improved due to rising geopolitical risks and economic stabilization in China. Commodities provide some ballast to a traditional equity/bond portfolio. Hedged Strategies (Hedge Funds and Managed Futures) Equal Weight This asset class can provide uncorrelated exposure to other risk-asset markets. It tends to work well in more challenging financial market conditions such as the current environment.
  17. 17. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 17 ON THE MARKETS Index Definitions S&P 500 INDEX Regarded as the best single gauge of the US equities market, this capitalization-weighted index includes a representative sample of 500 leading companies in leading industries of the US economy. S&P HEALTH CARE INDEX This index comprises the health care stocks that are in the S&P 500. MSCI DEVELOPED MARKETS INDEX This free- float-adjusted capitalization-weighted index is designed to measure the equity market performance of 24 developed markets. MSCI EUROPE INDEX This free-float-adjusted capitalization-weighted index is designed to measure the performance of 16 developed European markets. MSCI EMERGING MARKETS INDEX This free- float-adjusted market-capitalization index is designed to measure equity market performance in 21 emerging markets. MSCI JAPAN INDEX This free-float-adjusted market-capitalization index is designed to track the equity market performance of Japanese securities listed on the Tokyo Stock Exchange, Osaka Stock Exchange, JASDAQ and the Nagoya Stock Exchange. MSCI USA INDEX This index is designed to measure the performance of the large- and mid- cap segments of the US equity market. With 586 constituents, the index covers approximately 84% of the free-float-adjusted market capitalization in the US.
  18. 18. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 18 ON THE MARKETS Disclosures Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events.
  19. 19. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 19 Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material. Morgan Stanley Wealth Management and its affiliates do not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used or relied upon by any recipient, for any purpose, including the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Each client should consult his/her personal tax and/or legal advisor to learn about any potential tax or other implications that may result from acting on a particular recommendation. This material is primarily authored by, and reflects the opinions of, Morgan Stanley Wealth Management Member SIPC, as well as identified guest authors. Articles contributed by employees of Morgan Stanley & Co. LLC (Member SIPC) or one of its affiliates are used under license from Morgan Stanley. International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. Alternative investments which may be referenced in this report, including private equity funds, real estate funds, hedge funds, managed futures funds, and funds of hedge funds, private equity, and managed futures funds, are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and risks associated with the operations, personnel and processes of the advisor. Managed futures investments are speculative, involve a high degree of risk, use significant leverage, have limited liquidity and/or may be generally illiquid, may incur substantial charges, may subject investors to conflicts of interest, and are usually suitable only for the risk capital portion of an investor’s portfolio. Before investing in any partnership and in order to make an informed decision, investors should read the applicable prospectus and/or offering documents carefully for additional information, including charges, expenses, and risks. Managed futures investments are not intended to replace equities or fixed income securities but rather may act as a complement to these asset categories in a diversified portfolio. Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond’s maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio. Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one's state of residence and, if applicable, local tax-exemption applies if securities are issued within one's city of residence. Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected. Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations. Treasury Inflation Protection Securities’ (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
  20. 20. Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | OCTOBER 2013 20 Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies. Interest income from taxable zero coupon bonds is subject to annual taxation as ordinary income even though no interest payments will be received by the investor if held in a taxable account. Zero coupon bonds may also experience greater price volatility than interest bearing fixed income securities because of their comparatively longer duration. Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change representative indices at any time. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Principal is returned on a monthly basis over the life of a mortgage-backed security. Principal prepayment can significantly affect the monthly income stream and the maturity of any type of MBS, including standard MBS, CMOs and Lottery Bonds. Yields and average lives are estimated based on prepayment assumptions and are subject to change based on actual prepayment of the mortgages in the underlying pools. The level of predictability of an MBS/CMO’s average life, and its market price, depends on the type of MBS/CMO class purchased and interest rate movements. In general, as interest rates fall, prepayment speeds are likely to increase, thus shortening the MBS/CMO’s average life and likely causing its market price to rise. Conversely, as interest rates rise, prepayment speeds are likely to decrease, thus lengthening average life and likely causing the MBS/CMO’s market price to fall. Some MBS/CMOs may have “original issue discount” (OID). OID occurs if the MBS/CMO’s original issue price is below its stated redemption price at maturity, and results in “imputed interest” that must be reported annually for tax purposes, resulting in a tax liability even though interest was not received. Investors are urged to consult their tax advisors for more information. Credit ratings are subject to change. Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom. Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, sale, exercise of rights or performance of obligations under any securities/instruments transaction. This material is disseminated in Australia to “retail clients” within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813). Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the research in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities. Morgan Stanley Private Wealth Management Ltd, authorized by the Prudential Regulatory Authority and regulated by the Financial Conduct Authority and the Prudential Regulatory Authority, approves for the purpose of section 21 of the Financial Services and Markets Act 2000, research for distribution in the United Kingdom. Morgan Stanley Wealth Management is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. Morgan Stanley Wealth Management research, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC. © 2013 Morgan Stanley Smith Barney LLC. Member SIPC.

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