Positioning. The Other Deflategate

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1 GLOBAL INVESTMENT COMMITTEE FEB. 18, 2015 Positioning The Other Deflategate Prior to the Super Bowl, the New England Patriots were accused of cheating in the AFC Championship game against the Indianapolis Colts by deflating their team footballs for that game. According to many, that would make the ball easier to grip for both the quarterback, Tom Brady, and his receivers especially on a cold, rainy night like during the Colts/Patriots game four weeks ago. MICHAEL WILSON Chief Investment Officer Morgan Stanley Wealth Management M.Wilson@morganstanley.com At the end of the day, however, most fans couldn t care less about Deflategate or whether the Patriots even did this on purpose. Of course, with the Patriots winning the Super Bowl and Tom Brady getting his third MVP award, Deflategate was put to bed as fast as it became national headlines. There could be some penalties for the Patriots and some fines to be paid, but there is unlikely to be an asterisk next to the Patriots W in Super Bowl XLIX. So why talk about it now if it s already forgotten? I bring it up because it appears to me that investors have a case of Deflategate. Ever since the financial crisis of , the biggest concern of investors has been deflation. To be honest, it s been one of the Global Investment Committee s (GIC) top concerns, too. Nor has this worry been lost on central bankers, who have been fighting tooth and nail to defeat deflation since late 2008 when the Federal Reserve launched its first Quantitative Easing (QE) program. By the end of 2013, central bankers appeared to be getting the upper hand on deflation as global equities enjoyed their best year since 1999 if you exclude those years following a US recession when stocks typically do very well i.e., 2003 and Last year, investors started to worry that the deflationary trend was reasserting itself. A 50% decline in oil prices didn t help, nor did a strong US dollar, which has a deflationary impact on pricing for many global goods ranging from commodities to semiconductors. As a result, 2014 turned into a year during which assets benefitting from deflation outperformed, led by the ultimate deflation hedge 30-year US Treasury bonds. The US equity market did well overall but it was led by defensive stocks like utilities, health care and large-cap technology shares. In fact, the collective US equity market, given its higher-quality characteristics, is the world s most defensive regional market. In a sense, the US equity market outperformed its global peers in 2014 because investors became skeptical of the recovery most everywhere else and worried once again about deflation. The GIC believes 2015 will prove to be a year in which deflationary fears could subside Please refer to important information, disclosures and qualifications at the end of this material.

2 anew, much as they did in This is partly due to the rebalancing of growth from the US to other regions of the world that we envision this year. Such rebalancing should dispel some of the fears that Europe is following Japan into a world of structural deflation and that Abenomics reforms have failed. Now, consider the massive QE programs in Europe and Japan, and the interest rate cuts in India, China, Canada, Australia, Sweden and Switzerland. Combine them with a 50% decline in oil prices, and we have more global monetary and fiscal stimulus than we have seen since 2009 when the US, the UK and China led the charge to restart the global economy. We find it hard to believe that this won t have a material effect on asset prices and growth in the near term. Nevertheless, it is hard to find constructive commentary in the media or the investment community about the recent actions by the European Central Bank (ECB) having any lasting effect. The good news is that markets have taken a more constructive view, as inflation expectations have risen sharply in both the US and Europe (see Exhibit 1). We see such moves as a significant vote of confidence by the markets that Deflategate for investors may turn out to be as irrelevant as it was for Tom Brady and the Patriots. If that is indeed true, then the defensive investments that led the market in 2014 will prove to be the wrong holdings for Indeed, that s exactly what we have been recommending and witnessing, with the market rotating toward reflationary investments since the end of January. Beyond the obvious rotation in performance from bonds to stocks, we are seeing the same thing within equity markets. To wit, energy, materials, financials and consumer discretionary as well as small- and midcap stocks have significantly outperformed in February while defensive sectors like utilities, health care and consumer staples Exhibit 1: Inflation Expectations Are Up Sharply in the US and Euro Zone 2.5% Five-Year Inflation Expectations US Euro Zone Source: Bloomberg as of Feb. 13, 2015 ECB QE have underperformed. Perhaps more important, this rotation away from defensives is happening in European and Japanese equity markets, too. From the GIC s perspective, this makes perfect sense and supports the idea that global growth and inflation are bottoming as our rebalancing thesis begins to play out. Therefore, we believe these more cyclical assets will likely continue to lead. Kicking the Can Euro Style During the past several weeks, headlines have been dominated by fears of Greece leaving the Euro Zone better known as the Grexit. While this is not a new risk, it has come to the fore as a result of the recent election in Greece won by the Syriza party. Syriza is the antiestablishment party in Greece, and it is trying to break the fiscal austerity forced upon the nation as the price of repeated financial lifelines. While most view this confrontation as a risk event for Europe, I see it as a potential catalyst for the next stage of the recovery. In fact, it could serve as a game changer for Europe much like the 2011 budget impasse and government debt downgrade was for the US. While this may seem crazy on the surface, the reality is that the US equity markets only started to outperform other regions in August 2011 after the downgrade of US Treasury debt (see Exhibit 2, page 3). Notice the extremely high correlation between the US equity market and other global markets until the downgrade, followed by sharp divergence thereafter. While this may look irrational, the explanation is quite reasonable. Treasuries were downgraded because Congress decided to kick the can down the road by not making the hard decision on fiscal discipline. While debt owners and rating agencies don t like that kind of behavior, it s generally shareholder friendly because it s progrowth. To be clear, Syriza s leaders are not asking to restructure the existing debt. Rather, they are simply asking that they not be forced to run a greater fiscal surplus. One thing that gets little attention is that Greece is already running a 1.5% primary fiscal surplus. Furthermore, Greece has already gone through a gutwrenching internal devaluation during the past four years. According to the Bank Credit Analyst, Greece s unit labor costs have fallen by 25% relative to the rest of the Euro Zone, completely eliminating the accumulated competitiveness gap that had built up since Meanwhile, the terms of the existing financial bailout that is under debate require Greece to increase its surplus to 4.5% by next year. That seems severe and austerity is not a path to prosperity, and Greece wants some relief. Based on the results in the US, there is a good case to be Please refer to important information, disclosures and qualifications at the end of this material. Feb. 18,

3 Exhibit 2: US Stocks Pulled Ahead After Congress Nixed Fiscal Austerity S&P 500 MSCI All Country World Index ex US 80 Greece Pushes 60 US Debt Back on Austerity Downgrade Measures Note: May 8, 2006 =100 Source: Bloomberg as of Feb. 12, 2015 made for less austerity as a better means to the end that everyone wants including Greece s creditors. The hold-up in this case could simply be good old-fashioned politics. Germany will hold elections next month, so it s awfully hard for German politicians to publicly acquiesce to any of Greece s demands. Therefore, it may just be a matter of time before a more practical solution can be officially negotiated and publicly communicated. Based on recent market action, it appears that this is the outcome starting to be discounted. The more important point is that this could be the beginning of the end of the European austerity and time for Europe to play its own version of kick the can. Earnings Still Matter the Most After a torrid run in US equities relative performance the past few years, the tide seems to be turning. Both Europe and Japan are outperforming the US this year in local currency and in USdollar terms. The GIC has been making the positive case for these two regions for a while on the premise that global growth would eventually rebalance. This is now happening and the market has noticed the better performance for these regions. Some of this is based on improving growth in Europe and Japan but some is also due to slowing growth in the US something few expected at the end of the year. As a reminder, there was a virtual 100% consensus view coming into this year that the global growth engine was running on one cylinder the US economy. Piled on top was a seemingly inept ECB and worsening geopolitical outlook for Russia/Ukraine, Greece, the Middle East and Africa. Despite this dim view, most believed US earnings would continue to chug ahead and few talked of the risks. Furthermore, most believed there was little hope for Europe, Japan and emerging markets to restart their economies. The GIC began highlighting the risk to US earnings in 2014 s fourth quarter. The primary culprits were expected to be the stronger US dollar and weaker energy prices. In fact, Adam Parker, Morgan Stanley & Co. s chief US equity strategist and GIC member, came into 2015 with an S&P 500 earnings estimate that was several percentage points below the consensus. Despite our more somber outlook for US profits, we remained overweight US equities because we thought this deceleration in earnings would be short-lived. Whenever exogenous shocks like a stronger currency and/or sharp moves in energy prices occur, the negative impacts are typically felt right away while the positive impacts take time to flow through to analyst estimates. For example, large US multinationals have quickly lowered their guidance for the full year to account for the strong dollar s negative translation impact on earnings. They will likely be slower to adjust numbers higher for the potentially stronger economic growth abroad as international economies benefit from the rebalancing of growth. The net result is that many of the 2015 estimates for US multinationals are now likely too low. Similarly, collapsing commodity prices have had an immediate negative impact on energy and materials companies while the benefits to consumer-oriented companies will likely not appear until later in the year when the windfall savings are viewed as more permanent and spent. Likewise, companies that benefit from lower energy costs have probably not factored that into their cost structure yet when providing guidance because they aren t sure if this is just a temporary drop or more permanent. Exhibit 3 shows the S&P 500 plotted against both actual trailing earnings per share (EPS) and the consensus forward 12-month Exhibit 3: Falling Forward Earnings Estimates Put a Brake on Stocks 2,200 $ 130 S&P 500 Price (left axis) 2,100 S&P 500 Next 12-Month 125 2,000 Earnings Estimate (right axis) S&P 500 Actual Quarterly 1,900 Earnings (annualized, right axis) 120 1, ,700 1, , ,400 1, , Source: Bloomberg as of Feb. 13, 2015 Please refer to important information, disclosures and qualifications at the end of this material. Feb. 18,

4 EPS estimate. As you can see, forward estimates have plummeted since October. As a result, the S&P 500 has not made much progress for the past three months. However, we think these negative revisions to earnings estimates are about finished, which is why the US equity market has recently rallied sharply. We believe US equities are beginning to look forward to higher revisions later in the year. Therefore, we believe US equities are likely to perform better than they have so far in 2015, and we remain overweight Europe, Japan and US equities across the GIC models. Please refer to important information, disclosures and qualifications at the end of this material. Feb. 18,

5 Index Definitions MSCI ALL COUNTRY WORLD INDEX EX US This free-float-adjusted marketcapitalization index is designed to measure equity performance in the emerging and all the developed markets except the US. 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 in the US economy. Risk Considerations 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. 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. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. 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. Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, 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. Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. 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. 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