Topics in Portfolio Construction From the Global Investment Committee

Transcription

1 Topics in Portfolio Construction From the Global Investment Committee Has the Credit Cycle Reached An Inflection Point? March 13, 2018 LISA SHALETT Managing Director JOSEPH PICKHARDT Assistant Vice President DANIEL HUNT Managing Director LUCY YAN Vice President AILI CHEN Assistant Vice President

2 Overview: Topics in Portfolio Construction Monthly publication from the Global Investment Committee (GIC) for clients and their Financial Advisors who seek to generate strong potential risk-adjusted performance over the next 12 months by applying quantitative analysis to the GIC s views. In this month s edition, we answer two key questions: 1. What Is Bond Market Weakness Telling Us? 2. What Exposures Does Our Quantitative Toolkit Recommend? Despite the partial recovery in equity prices, rates are still elevated and credit spreads have continued to widen. While these moves remain modest in historical context, corporate leverage has grown significantly, while investment grade index quality has deteriorated. Furthermore, current rich valuations in credit are unlikely to persist. While the fundamental backdrop largely remains intact, we recommend avoiding credit risk at this point in the cycle. Prefer highquality, short-duration bonds and remain overweight equities. As global dispersion increases and late-cycle risks rise, our quantitative toolkit recommends the following positions across asset classes: within equities, our factorbased tactical equity framework prefers Japan, the UK, and the US, with a preference for implementation via active management. Our term premium model continues to prefer short duration, as long duration does not offer significant value relative to history. We recommend implementation via US Securitized and US IG Short Duration bonds. Page 2

3 Question 1: What Is Bond Market Weakness Telling Us? KEY TAKEAWAYS Despite the partial recovery in equity prices, credit spreads have continued to widen and rates have remained elevated due to rising real rates and inflation expectations (top left). Credit markets have grown significantly, leading to the highest levels of Investment Grade leverage since the Tech Bubble (top right). Risks to Investment Grade credit now appear higher as lower-quality issuers have a much larger weight in the index. Normalizing for leverage levels, credit spreads stand at or beyond previous tights (bottom left). These rich valuations are unlikely to persist. We recommend avoiding credit risk, and prefer short-duration fixed income. We remain overweight equities, as global growth is strong and late-cycle equity gains have historically continued despite widening credit spreads (bottom right). Changes in Composition of US Interest Rates 1 Change in Composition of UST10Y Yield Real Rates Inflation Nominal +28 Real Rates Inflation Nominal YTD US IG Spread per Unit of Gross Leverage IG SPL IG Median SPL US Investment Grade Leverage Recession Net Leverage S&P IG Spreads (Inverted) 2007 Gross Leverage Credit and Equity Divergence in Late Cycle 4 Beginning of Recession Sep 2006 Dec 2006 Mar 2007 Jun 2007 Sep 2007 Dec 2007 Source: Morgan Stanley Wealth Management GIC, Bloomberg, FactSet. Note: 1) As of March 6, ) As of September 30, ) As of February 27, ) As of March 6, Page 3

4 Question 2: What Exposures Does Our Quantitative Toolkit Recommend? KEY TAKEAWAYS As global dispersion increases and latecycle risks rise, our quantitative toolkit recommends the following positions across asset classes: Our factor-based tactical equity framework prefers Japan, the UK, and the US (top left) on positive earnings revision and attractive profitability. We continue to prefer active management within equities (top right). As late-cycle volatility continues and policy changes increase equity dispersion, we believe stock selection will be critical. Our term premium model continues to prefer short duration, as long duration does not offer significant value relative to history (bottom left). Within fixed income, US Securitized and US IG Short Duration bonds offer attractive potential returns with lower rate and credit spread exposure (bottom right). Cap-Weighted Modeled Return of Equities by Region 1 Active/Passive Allocation Recommendations 2 United States China-A Europe Japan Emerging Markets United Kingdom Other Developed Markets Treasury Term Premium Framework 3 Bond Classes with Highest Expected Returns 4 Prefers Long Duration Prefers Short Duration Momentum Term Premium Rising Term Premium Falling Term Premium High March 7, 2018 March 2017 Value Term Premium Low Short Duration RATE EXPOSURE HIGH LOW February End Tactical Allocation Passive Active (%) (%) Active (%) CREDIT EXPOSURE LOW HIGH US Securitized (3.95%) US Agg Int. (3.60%) US Agg Short (2.72%) US Agg Long (4.26%) Strategic Allocation EM Europe (5.00%) US HY Corp (4.00%) EM Latam (6.59%) EM Credit (5.21%) Passive (%) Large Growth 15% 85% 45% 55% Large Value 75% 25% 45% 55% Mid Growth 55% 45% 55% 45% Mid Value 85% 15% 55% 45% Small Growth 40% 60% 70% 30% Small Value 70% 30% 70% 30% Source: FactSet, Bloomberg, Morgan Stanley Wealth Management GIC, Note: 1) As of March 8, ) As of February 28, ) As of March 7, 2018, 4) As of February 28, Page 4

5 Table of Contents Question 1: What Is Bond Market Weakness Telling Us? 6 Volatility Has Remained Elevated; Bond Weakness Has Persisted 7 Higher Inflation Expectations Point to Tighter Fed Policy 8 Tighter Fed Policy Appears Appropriate; Unlikely to Derail Cycle in Near Term 9 Inflation Unlikely to Break Out Given Central Bank Policy, Secular Forces 10 Corporate Leverage Has Grown Significantly, Creating Risk for Credit 11 Credit Stress Could Be Amplified By Quality, Liquidity Concerns 12 Economic Fundamentals Healthy, But May Be Turning 13 Higher Global Rates Now Offer Foreign Investors Alternatives to US Credit 14 Underweight Credit; Prefer Short Duration, Equities 15 We Recommend Cheap, High-Quality Exposures With Manageable Debt Levels 16 Question 2: What Exposures Does Our Quantitative Toolkit Recommend? 17 Tactical Equity Framework: Modeled Relative Performance by Region 18 Tactical Equity Framework: Global Quantitative Factor Attractiveness 19 Our Factor-Based Active/Passive Framework 20 Term Premium Framework Remains Underweight Long-Duration Bonds 21 Tactical Fixed Income Framework: Managing Risk Across Rates and Credit 22 Current Readings Suggest USD Weakness 23 Our Views for Asset Allocation Based on Our Quantitative Tools 24 Page 5

6 Question 1: What Is Bond Market Weakness Telling Us? Page 6

7 Volatility Has Remained Elevated; Bond Weakness Has Persisted Markets have remained volatile across asset classes following the sharp equity correction in early February. Although equities have recovered some of their initial losses, questions regarding the path of Federal Reserve policy and the potential for US tariffs to ignite a trade war continue to concern market participants. Despite the partial recovery in equities, credit spreads have continued to widen (though they remain quite low by historical standards), and interest rates remain near 5-year highs. As markets grapple with rising uncertainty and late-cycle dynamics, what is this nascent weakness in the bond market telling us? Despite the partial recovery in equities, volatility across asset classes has remained elevated following the early February correction... Volatility: VIX Index, MOVE Index, and CVIX Index As of March 8, 2018; Z-score 3.5 Currency Volatility Fixed Income Volatility 3 Equity Volatility Jan '17 Feb Mar Apr May Jun '17 '17 '17 '17 '17 Jul '17 Aug '17 Sep '17 Oct '17 Nov '17 Dec '17 Jan '18 Feb Mar '18 ' US 10-Year (Left, Indexed) US HY Spread (Left, Indexed) S&P 500 (Right) Bond Market Weakness... While interest rates hold near 5-year highs and credit spreads continue to widen from cycle lows. S&P 500, US High Yield Spreads, US 10 Year Treasury Rate As of March 6, Source: Bloomberg, Morgan Stanley Wealth Management GIC. Z-score is a statistical measurement of a score's relationship to the mean in a group of scores. A z-score of 0 means the score is the same as the mean. Page 7

8 Higher Inflation Expectations Point to Tighter Fed Policy Bond Market Weakness This year s increase in nominal yields has been led by an increase in real rates, as markets have priced in faster Fed hikes and higher growth expectations. Inflation expectations have also contributed to a rise in nominal rates, as the prospects for higher deficit spending, continued dollar weakness, and the threat of rising global protectionism add to late-cycle inflationary pressures. These changes in the bond market imply that investors are now pricing in a steeper pace of rate hikes, in line with the Fed s previous guidance of three hikes. Recent testimony by Fed Chair Jerome Powell has fueled speculation that the Fed may lean more hawkish, increasing the potential of four hikes in As we have noted before, this increase in policy uncertainty has led to higher volatility, as is typical of late-cycle environments. Rising real rates and inflation expectations have both fueled this year s significant rate move... Changes in Composition of US Interest Rates As of March 6, 2018 Change in Composition of UST10Y Yield Real Rates Inflation Nominal Real Rates Inflation Nominal YTD... As investors are now pricing in three rate hikes for 2018, with speculation that the Fed may adopt a more hawkish path. Fed Projected and Market Implied Path As of March 5, % 7% 5% 3% 1% -1% -3% Recession Historical Fed Funds Rate Median Fed Projection Atlanta Fed Wu Xia Shadow Federal Funds Rate Current Market-Implied Path E 2018 E 2020 Source: Bloomberg, Morgan Stanley Wealth Management GIC Page 8

9 Tighter Fed Policy Appears Appropriate; Unlikely to Derail Cycle in Near Term As we approach the later stages of the business cycle, tight labor markets, as signified by unemployment below the natural rate, are causing wage growth to accelerate. As a result, the Fed is becoming more confident that inflation will rise toward its 2% target. Despite five interest rate hikes this cycle, monetary policy remains accommodative, as evidenced by the gap between the real Fed Funds Rate and the neutral real rate. With the economy now running above its long-term potential growth rate and inflationary pressures building, a tighter Fed seems appropriate to rein in risks. Financial conditions remain extraordinarily loose, suggesting markets can likely withstand further tightening. Tighter labor markets are causing wage growth to accelerate But Fed policy remains accommodative, suggesting further hikes are appropriate Loose financial conditions suggest markets can likely withstand further tightening. Wage Growth and Labor Market Slack 1 As of February 5, 2018 Average Hourly Earnings YoY% 3.2% 2.8% 2.4% 2.0% Today In 6 months (Predicted) Q Q Q Q % -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% Natural Rate of Unemployment Gap (Lagged 2 Quarters) Real Fed Funds Rate vs. Neutral Rate 2 As of January 31, % 4% 2% 0% Neutral Rate Real Fed Funds Rate 1 Recession 0.9-2% Source: Bureau of Labor Statistics, Bloomberg, Haver Analytics, Morgan Stanley Wealth Management GIC. Note: (1) The Phillips curve is an economic concept developed by A. W. Phillips showing that inflation and unemployment have a stable and inverse relationship. The Average Hourly Earnings YoY% was obtained as of February 2, 2018, and Natural Rate of Unemployment Gap estimate as of Q ) Real Fed Funds Rate adjusted for Core PCE YoY as of January 31, Jan '14 Looser Financial Conditions Jun '14 Nov '14 Apr '15 Sep '15 Bond Market Weakness Morgan Stanley Financial Conditions Index (US) As of March 5, 2018 Feb '16 Jul '16 Tighter Financial Conditions Dec '16 May '17 Oct '17 Mar '18 Page 9

10 Inflation Unlikely to Break Out Given Central Bank Policy, Secular Forces xxxxxx We expect inflation to remain moderate as central bank policy contains cyclical inflationary pressures... G4 Core Inflation and Inflation Forecasts 2 As of January 31, MS F'casts As of January 31, Phillips Curve Core Inflation (YoY) 2.0 Non Phillips Curve Core Inflation (YoY) Bond Market Weakness We expect inflation to remain moderate as central bank policy across the developed world contains cyclical inflationary pressures. Furthermore, secular deflationary forces, including aging demographics and efficiency-enhancing technology innovation, are likely to keep downward pressure on long-term demand growth and prices. Our colleagues in MS & Co. have analyzed the components of core inflation. While some components have historically risen in periods of tighter employment, other components have shown less sensitivity. These less wage-dependent components have been a drag on headline inflation this cycle, likely influenced by deflationary secular forces. xxxxxxx Wage-sensitive inflation components have reacted to labor market tightness, but others have been a drag on headline inflation. Core Inflation By Phillips Curve Sensitivity US EA Japan UK G Jun'09 Dec'09 Jun'10 Dec'10 Jun'11 Dec'11 Jun'12 Dec'12 Jun'13 Dec'13 Jun'14 Dec'14 Jun'15 Dec'15 Jun'16 Dec'16 Jun'17 Dec'17 Source: Morgan Stanley & Co., Morgan Stanley Wealth Management GIC. Note: (1) The Boom is Off the Rose, Global Interest Rate Strategist, Morgan Stanley & Co., March 3, 2018 (2) The Fundamentals Are Fine, Global Macro Briefing, Morgan Stanley & Co., February 14, 2018 (3) Phillips Curve core inflation includes shelter and core services; Non Philips Curve core inflation includes healthcare and core goods. Page 10

11 Corporate Leverage Has Grown Significantly, Creating Risk for Credit Abetted by an extraordinarily low interest rate environment, US corporate debt levels have grown significantly this cycle. US business sector debt has reached 70% of US GDP, which approaches all-time highs. This has pushed both gross and net leverage ratios for US Investment Grade companies beyond pre-crisis highs, suggesting elevated risks to the asset class. To put valuations into perspective, MS & Co. normalized credit spreads for the level of leverage for investment grade and high yield issuers 1. Viewed this way, both asset classes are trading at credit spreads at or beyond previous tights. With credit priced for perfection, we recommend investors be selective in the asset class and limit credit exposure. US Business Sector Debt to GDP is near all... Leading leverage ratios to levels not seen... While credit spreads, when adjusted for time highs... since the Tech Bubble... leverage, are at or beyond previous tights. US Nonfin. Business Sector Debt to GDP US Investment Grade Leverage US IG and HY Spread per Unit of Gross Leverage As of December 31, % 75% 70% 65% 60% 55% 50% 45% Recession Nonfinancial Business Sector Debt to GDP As of September 30, Recession Gross Leverage Net Leverage As of February 27, Bond Market Weakness IG SPL IG Median SPL 300 HY SPL 250 HY Median SPL Source: Haver Analytics, Morgan Stanley Wealth Management GIC, Morgan Stanley & Co. Research, Bloomberg Finance LP, S&P Capital IQ, Moody s, The Yield Book Software and Services FTSE Index LLC. All rights reserved. Note: (1) 2018 US Credit Strategy Outlook: When the Levee Breaks, Morgan Stanley & Co., January 2018 Page 11

12 Credit Stress Could Be Amplified By Quality, Liquidity Concerns Bond Market Weakness In addition to the overall leverage in the market, investment grade issuance has been concentrated in lower-quality segments. Gross leverage in the lowest-rated investment grade category, BBB, has outpaced AA leverage. Consequently, more than half of the investment grade index now consists of BBB rated companies, increasing the potential for downgrades and defaults in investment grade portfolios. While index quality is now lower, market structure has changed, with corporate bond ownership less concentrated among supplier of liquidity dealer inventory and more concentrated in vehicles subject to daily redemptions or even higher liquidity requirements, such as mutual funds and ETFs. This potential liquidity mismatch could cause any market selloff to become disorderly. IG leverage is growing faster among lower quality issuers, leading their weight in the index to grow significantly US IG Gross Leverage By Rating 1 As of September 30, 2017 Ownership is now more concentrated in vehicles subject to high liquidity requirements, which could cause a selloff to become disorderly. % of US Corporate Bonds Held by Mutual Funds/ETFs & Broker Dealers As of September 31, % BBB % of Market (Left) AA % of Market (Left) AA Leverage (Right) BBB Leverage (Right) 50% 40% 30% 20% 10% 0% Percent of US Corporate Bond Market 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Mutual Fund & ETF Holdings Broker Dealer Holdings Source: Morgan Stanley Wealth Management GIC, Morgan Stanley & Co., Moody s, Haver Analytics. Note: (1) 2018 US Credit Strategy Outlook: When the Levee Breaks, Morgan Stanley & Co., January 2018 Page 12

13 Economic Fundamentals Healthy, but May Be Turning Bond Market Weakness Economic fundamentals do not suggest imminent credit stress: overall loan delinquencies remain at cycle lows, with real estate delinquencies low and commercial and industrial delinquencies continuing to recover from the industrial recession of However, consumer loan delinquencies, including credit cards and auto loans, appear to be rising a sign that has preceded the last three recessions. Our cycle indicator confirms this divergence: While the more volatile manufacturing sector remains strong, the consumer cycle appears to be in its later stages. While this is a risk, investors should keep in mind that post-crisis deleveraging has kept the ratio of financial obligations to disposable income at 25 year lows even after adjusting for the shift from home ownership to renting. This could soften the impact of the next recession. While overall loan delinquencies remain at cycle lows, the consumer cycle appears to be turning... Loan Delinquency Rate: All Insured Commercial Banks As of December 31, % 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Recession Consumer Loans C & I Loans Overall Real Estate Loans Corroborated by our cycle indicator, which suggests the US consumer cycle is in its later stages despite manufacturing strength. Cycle Indicator: Consumer and Manufacturing Cycle As of March 7, Recession Manufacturing Cycle Consumer Cycle Source: Haver Analytics, Morgan Stanley Wealth Management GIC Page 13

14 Foreign investors today hold nearly 30% of all US corporate bonds, a large increase from prior decades. Much of this change can be attributed to global quantitative easing, which suppressed sovereign and corporate yields. Yield-starved investors turned to the US, where credit markets are deeper and offered higher yields, further supported by stronger US economic growth compared to other global regions. However, improved global growth today has caused global yields to rise and the US dollar to weaken, increasing the relative attractiveness of alternatives to US credit. Additionally, higher Treasury issuance and continued runoff of the Federal Reserve balance sheet have caused Treasury yields to rise. This could put additional upward pressure on US credit spreads by attracting flows away from US credit. Foreign investors today hold nearly 30% of US corporate bonds... US Corporate Bond Ownership As of September 30, 2017 CEF/ETF Mgd. Retirement Funds Insurance Non-US Investors 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Other Mutual Funds Financial Institutions Household Today... But alternatives now offer higher yields... Japanese Investor Fixed Income Yields As of March 8, 2018 (US Yields Are Currency Hedged to JPY) Yields (Currency Hedged) 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% 7/8/2016 Today US 10Yr US IG JGB 30 Yr JGB 10Yr... And higher Treasury issuance and Fed QE runoff may reverse flows from Treasuries to Credit. Foreign Sector Ownership of US Bonds As of September 30, 2017 Billions, USD Treasury Securities Agency & GSE-backed Securities U.S. Corporate Bonds Bond Market Weakness Higher Global Rates Now Offer Foreign Investors Alternatives to US Credit Source: MS & C0. Research, Haver Analytics, Bloomberg, Morgan Stanley Wealth Management GIC Page 14

15 Underweight Credit; Prefer Short Duration, Equities Bond Market Weakness Given exceptionally rich valuations and the aforementioned risks associated with credit today, we recommend limiting exposure. Within fixed income, we prefer high-quality, short-duration bonds, which offer lower sensitivity to rising credit spreads and interest rates. Our quantitative tactical fixed income framework suggests US Securitized and Short Duration Investment Grade bonds offer the highest expected risk-adjusted returns. We remain constructive on equities as global growth remains strong, but recommend implementing US exposure with an emphasis on active management that can better navigate higher volatility. We note that late-cycle equity gains have continued despite widening credit spreads in previous cycles a pattern that may now be emerging in today s markets. Within fixed income, high-quality, short-duration bonds and securitized fixed income offer more attractive risk/reward Expected Return vs. Spread Sensitivity As of February 28, 2018 Yield & Return from Roll 4% US Securitized 2% 0% More Attractive International Agg Global Agg Short US Agg Short US Agg Intermediate Global Agg US HY Corp US Agg Global HY Corp Spread Sensitivity Less Attractive Late in the business cycle, stocks have continued to post gains while credit spreads have widened... Credit and Equity Divergence in Late Cycle As of March 6, S&P IG Spreads (Inverted) 200 Beginning of Recession 250 Sep 2006 Dec 2006 Mar 2007 Jun 2007 Sep 2007 Dec S&P IG Spreads (Inverted) Beginning of Recession 600 Nov 1999 Feb 2000 May 2000 Aug 2000 Nov 2000 Feb 2001 Source: MS & Co. Research, Morgan Stanley Wealth Management GIC, Bloomberg, Datastream, Moody s. EM fixed income asset classes are represented by the corresponding JPMorgan EMBI Indices, other fixed income asset classes by the corresponding Bloomberg Barclays Indices Page 15

16 Bond Market Weakness We Recommend Cheap, High-Quality Exposures With Manageable Debt Levels We recommend attractively valued equities that have shown stronger ability to meet their interest expenses. While Value exposures are more levered to strong economic growth, strong interest coverage ratios suggest potential downside cushion should credit stress appear across markets. We overlay a preference for High-Quality companies, which have more stable and higher-quality earnings to further manage risks. We also refine our recommendations according to our quantitative factor-based Tactical Equity Framework. Below we show the countries, region / sector combinations, and US subindustries that may benefit from continued global growth acceleration and upward pressure on interest rates. Top Countries, Region/Sectors by Select Factors As of March 8, 2018 DEEP VALUE HIGH QUALITY INTEREST COVERAGE OVERALL Taiwan Turkey Japan Finland Bermuda Spain REGION COUNTRY SECTOR RANKS (1= BEST, 10= WORST) DEEP VALUE RANKS (1= BEST, 10= WORST) HIGH INTEREST QUALITY COVERAGE OVERALL JP Consumer Discr JP Industrials JP Technology JP Materials EM Telecomm JP Consumer Staples JP Health Care Top US Subindustries by Select Factors As of March 8, 2018 US SUBINDUSTRY DEEP VALUE RANKS (1= BEST, 10= WORST) HIGH QUALITY INTEREST COVERAGE OVERALL Computer & Electronics Retail Drug Retail Household Appliances Communications Equipment Health Care Distributors Hypermarkets & Super Centers Homefurnishing Retail Movies & Entertainment Household Products IT Consulting & Other Services Apparel Accessories & Luxury Goods Industrial Conglomerates Source: Morgan Stanley Wealth Management GIC, FactSet. For definitions of factors and universes, please reference our special report, Tactical Equity Allocation: Introducing a Systematic Framework for Short-Term Investment Views, December Page 16

17 Question 2: What Exposures Does Our Quantitative Toolkit Recommend? Page 17

18 Tactical Equity Framework: Modeled Relative Performance by Region Cap-Weighted Modeled Excess Return of Equities by Region 1 As of March 8, 2018 United States, Modeled Return: 0.53% China-A, Modeled Return: -3.45% Europe, Modeled Return: -0.78% Emerging Markets, Modeled Return: -0.37% Japan, Modeled Return: 1.39% United Kingdom, Modeled Return: 1.08% Other Developed Markets, Modeled Return: 0.18% Quantitative Dashboard Cap-Weighted Modeled Excess Return of Equities by Country As of March 8, 2018 Country Modeled Returns China-H 2.99% Russian Federation 2.56% Taiwan 2.37% United States 2.33% Japan 2.01% Australia 1.96% South Korea 1.43% United Kingdom 0.90% Canada 0.79% Netherlands 0.72% Hong Kong 0.68% Brazil 0.51% Italy 0.37% Singapore 0.28% Ireland 0.12% Spain 0.00% Saudi Arabia -0.09% Germany -0.15% South Africa -0.20% Mexico -0.35% Thailand -0.41% France -0.59% Denmark -0.60% Sweden -0.68% Switzerland -1.00% Belgium -1.02% China-A -1.77% Indonesia -2.16% Malaysia -2.73% India -2.74% Source: FactSet, Morgan Stanley Wealth Management GIC. For definitions of factors and universes, please reference our special report, Tactical Equity Allocation: Introducing a Systematic Framework for Short-Term Investment Views, dated December Note: (1) Modeled return scores attempt to forecast the relative performance of each region over the next 12 months relative to cap-weighted global equities.size of regions in chart corresponds to the proportion of global market cap within each region. Page 18

19 Quantitative Dashboard Tactical Equity Framework: Global Quantitative Factor Attractiveness Based on our Tactical Equity Framework, this slide measures the relative strengths and weaknesses of regions by factor attractiveness. Regional Factor and Total Score Attractiveness Over Next 12 Months Relative to Global Equities As of March 8, 2018 Deep Value Near-Term Value Momentum Earnings Revisions Profitability Earnings Quality Total Yield Capital Use Overall United States Japan Europe UK Other Developed Markets China-A China-H India Other Emerging Markets Least Attractive Neutral Most Attractive Source: FactSet, Morgan Stanley Wealth Management GIC. Green shading indicates a factor has improved, red shading indicates that a factor has worsened. This represents attractiveness based on a market capitalization-weighted basis. For definitions of factors and universes, please reference our special report, Tactical Equity Allocation: Introducing a Systematic Framework for Short-Term Investment Views, December 2015 Page 19

20 Our Factor-Based Active/Passive Framework Quantitative Dashboard We continue to be constructive on the outlook for active management, especially among Value-style equities and Mid/Small cap equities. As latecycle volatility continues and policy changes increase stock dispersion, we believe stock selection will be critical for investment results. However, the spike in correlations seen during the recent equity correction caused our Tactical Active / Passive Framework to shift somewhat toward passive management in Large Core, Large Growth, and Small Growth. We note, however, that this spike in correlations was exacerbated by the unwinding of massive short volatility positions, and forced selling by various programmatic strategies. While we believe volatility will remain elevated, we do not expect correlations to hold these levels as the market continues to focus more on idiosyncratic stock characteristics. Tactical Active/Passive Allocation Recommendations As of February 28, 2018 February End Tactical Allocation Strategic Allocation Active (%) Passive (%) Active (%) Passive (%) Large Core 15% 85% 45% 55% Large Growth 15% 85% 45% 55% Large Value 75% 25% 45% 55% Mid Core 55% 45% 55% 45% Mid Growth 55% 45% 55% 45% Mid Value 85% 15% 55% 45% Small Core 40% 60% 70% 30% Small Growth 40% 60% 70% 30% Small Value 70% 30% 70% 30% Factor Model Weights for Select Styles and Current Signals As of February 28, 2018 Factors Large Core Mid Core Small Core Current Signal Last 6M Signal Trend Last 12M Signal Trend Value Dispersion 20% 25% 15% Moderate Active Active Active S&P Macro Sensitivity Trend 14% 22% 12% Strong Active Active Active Trailing Return Breadth 11% 6% 9% Strong Active Active Active Trailing Global vs. US Return 11% 4% 12% Strong Passive Passive Passive Return Correlation 7% 13% 19% Strong Passive Passive Passive Return Correlation Trend 16% 8% 8% Strong Passive Passive Passive Yield Slope 2% 11% 3% Moderate Passive Active Neutral Yield Slope Trend 8% 3% 1% Strong Active Active Active Modeled Return Breadth 7% 6% 11% Moderate Passive Passive Passive Earnings Estimate Dispersion 5% 2% 10% Strong Active Active Active Source: Morningstar, Morgan Stanley Wealth Management GIC, Bloomberg Page 20

21 Despite recent upside to interest rates, we continue to prefer short-duration rather than long-duration bonds. Much of the rise in longer-term yields has been due to a higher risk-neutral rate, as investors have priced higher expectations for the path of monetary tightening and short rates over the next 10 years. The term premium, or the risk compensation associated with holding longer-dated bonds, has risen less and remains negative. While downward momentum in the term premium has abated, our framework still does not see value in holding long-duration bonds rather than short duration. Duration Framework Based on the US 10-Year Treasury Term Premium 1 As of March 7, 2018 Quantitative Dashboard Term Premium Framework Remains Underweight Long-Duration Bonds Long-Term Chart: US 10-Year Treasury Term Premium 1 As of March 7, 2018 Prefers Long Duration Prefers Short Duration Term Premium High Value Term Premium Low 3.0% 2.0% 1.0% Term Premium Rising 0.0% -1.0% Momentum Term Premium Falling March 7, 2018 March 2017 Short Duration Trailing One-Year Chart: US 10-Year Treasury Term Premium 1 As of March 7, % Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 Source: Federal Reserve Bank of New York, Haver Analytics, Morgan Stanley Wealth Management GIC. (1) The term premium is the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds. Note: When the indicator is in the green boxes, longer duration potentially looks more attractive. In the red boxes, shorter duration potentially looks more attractive. For more information regarding the framework, please see Using the Term Premium to Manage Portfolio Duration, published on March 30, Standard deviation (volatility) is a measure of the dispersion of a set of data from its mean. 0.1% 0.0% -0.1% -0.2% -0.3% -0.4% -0.5% -0.6% Page 21

22 Quantitative Dashboard Tactical Fixed Income Framework: Managing Risk Across Rates and Credit In order to compare fixed income asset classes and identify the most attractive opportunities, we classify them according to their credit and rate risk in the table below. In each quadrant, we list the instruments with the highest expected total return according to our framework based on yield, roll, and expected credit loss. Given our focus on short duration and low credit risk, US Securitized and Short/Intermediate duration US IG fixed income appear the most attractive. EM fixed income offers high expected total returns, in part due to the fact that EM economies are largely earlier in the business cycle than the US. Within a broad asset allocation, we prefer sourcing EM exposure from equities rather than credit. Bond Classes with Highest Expected Returns As of February 28, 2018 LOW CREDIT EXPOSURE HIGH RATE EXPOSURE LOW HIGH US Securitized (3.95%) US Agg Intermediate (3.60%) US Agg Short (2.72%) US Agg Long (4.26%) EM Europe (5.00%) US HY Corp (4.00%) EM Latam (6.59%) EM Credit (5.21%) Source: Morgan Stanley Wealth Management GIC, Bloomberg, Datastream, Moody s. EM fixed income asset classes are represented by the corresponding JPMorgan EMBI Indices, other fixed income asset classes by the corresponding Bloomberg Barclays Indices. Page 22

23 Current Readings Suggest USD Weakness Quantitative Dashboard Current signals in our dynamic framework recommend no hedging on all G6 currencies, as our basket appears likely to strengthen or hold steady versus the USD. Overall, the US Dollar appears likely to continue to depreciate, primarily based on the Value, Economics, Momentum and Sentiment factors. Consistent with our dynamic methodology, the GIC is currently recommending unhedged Euro exposure and unhedged JPY exposure. Europe and Japan are still at earlier stage of the business cycle than the US, and as their central banks start tightening monetary policy on the prospect of strong growth, these currencies could strengthen further. Current Indicator Readings Across Currencies 1 As of February 28, 2018 Value Economics Momentum Sentiment Carry Factor Framework INDIVIDUAL CURRENCY VERSUS USD (+ BULLISH/UNHEDGE; BEARISH/HEDGE) USD VS DXY BASKET (+ BULLISH ON USD; BEARISH ON USD) GBP EUR JPY CHF CAD SEK Weighted Avg REER PPP NA Core CPI Industrial Production NA NA + Currency Momentum NA + + Equity Momentum + NA CFTC Net Positioning NA Volatility + NA Crude Price NA NA NA NA + NA Nominal Yield NA NA Forward Implied Yield Overall Recommendation Source: Morgan Stanley Wealth Management GIC, Bloomberg, Haver Analytics. Note: (1) NA indicates that certain factors are not being used for certain currencies. GBP= British Pound, EUR= Euro, CAD= Canadian Dollar, SEK= Swedish Krona, JPY= Japanese Yen, CHF= Swiss Franc; all currencies are quoted against USD Page 23

24 Our Views on Asset Allocation Based on Our Quantitative Tools Quant Indicators: Multi-Asset - Rationale Stocks / Bonds Bonds Stocks Strong economic and earnings growth and a reinvigorated reflationary impulse positive for stocks. Relative earnings yields attractive, but more so outside the US. Risks from geopolitics, US policy execution, rising interest rates and potentially tightening financial conditions, elevated US valuations, and possible inflationary margin pressures weigh. Regional Preferences Quant Indicators: Equities US Europe UK Japan Other DM EM Bearish Bearish Bearish Bearish Bearish Bearish Quant Indicators: Fixed Income Rationale - Rationale High-quality, strengthening earnings and solid economic Improving cyclical impulse has benefitted credit, backdrop; fiscal stimulus a boost but expectations have risen; Credit / and defaults appear contained, but narrow Bullish Rising inflation may pressure margins and encourage tighter Rates Credit Rates spreads suggest valuations are aggressive. Fed policy, interest rate risks, geopolitics, trade fears, and Preference for higher quality. high valuations weigh on further potential upside Bullish Bullish Bullish Bullish Bullish Stronger growth, rising earnings expectations are encouraging, and valuations and total yields are attractive; Political, Brexit/EU negotiation; ECB execution risks weigh Industrial, exporting companies have benefitted from global cyclicality and GBP weakening; valuation and total yield attractive; risk of political and Brexit uncertainty/recent GBP volatility constraining economic activity Forecast earnings growth is encouraging, yield-targeting BOJ policies appear effective, and high-quality, attractively valued companies carry a strong factor profile; key risks include ongoing efficacy of monetary/fiscal policy and "Abenomics" reforms Attractive valuation and ample total yields 1 favorable; profitability has strengthened, may improve further from commodity-induced strength Improved current accounts, strong earnings growth, effects of softened USD and valuations remain attractive, but higher rates, potential tightening of US trade policy poses risk; prefer China H, Korea, Taiwan to China A, India, and Latin America Short / Long Duration - Rationale Hedged / Unhedged Hedged No Hedge Term premiums remain low despite recent uptick in rates; await further increases before extending duration. More attractive risk/return profile in short duration. Source: Morgan Stanley Wealth Management GIC. Note: 1) Total yield is dividends paid plus net shares repurchased divided by market cap. ++ is most attractive, + is moderately attractive, 0 is neutral, - is moderately unattractive, -- is most unattractive. Term premium is the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds. Short Quant Indicators: Currency Quant Indicators: Active vs. Passive Active / Passive (US Only vs Strategic) Long Remove 50% JPY hedge based on accelerating growth and rising inflows. - Rationale US has shifted to preference for active; potential for rising earnings dispersion and correlation Passive Active falling from high levels driven by late cycle dynamics suggest move toward active may continue. Page 24

25 Glossary and Risk Considerations ALPHA The excess return of an investment relative to the return of a benchmark index. BETA A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. CORRELATION This is statistical measure of how two securities move in relation to each other. This measure is often converted into what is known as correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation coefficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random. A correlation greater than 0.8 is generally described as strong, whereas a correlation less than 0.5 is generally described as weak. DISPERSION is a measure for the statistical distribution of portfolio returns. It is the asset-weighted standard deviation of individual portfolio returns within a comparable composite from the composite return. DRAWDOWN is the peak-to-trough decline during a specific recorded period of an investment, fund or commodity. INFORMATION RATIO (IR) is a ratio of portfolio returns above the returns of a benchmark usually an index to the volatility of those returns. Risk Considerations Daniel Hunt, Joseph Pickhardt, Lucy Yan and Aili Chen are not members of the Global Investment Committee and any implementation strategies suggested have not been reviewed or approved by the Global Investment Committee. For index, indicator and survey definitions referenced in this report please visit the following: Hypothetical Performance General: Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Hypothetical performance results have inherent limitations. The performance shown here is simulated performance based on benchmark indices, not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results achieved by a particular asset allocation. Despite the limitations of hypothetical performance, these hypothetical performance results may allow clients and Financial Advisors to obtain a sense of the risk / return trade-off of different asset allocation constructs. Investing in the market entails the risk of market volatility. The value of all types of securities may increase or decrease over varying time periods. Master Limited Partnerships (MLPs) Individual MLPs are publicly traded partnerships that have unique risks related to their structure. These include, but are not limited to, their reliance on the capital markets to fund growth, adverse ruling on the current tax treatment of distributions (typically mostly tax deferred), and commodity volume risk. The potential tax benefits from investing in MLPs depend on their being treated as partnerships for federal income tax purposes and, if the MLP is deemed to be a corporation, then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund which could result in a reduction of the fund s value. MLPs carry interest rate risk and may underperform in a rising interest rate environment. Derivative instruments: Options, futures contracts, options on futures contracts, forward contracts, swaps and structured products are examples of derivative instruments. Risks of derivative instruments include imperfect correlation between the value of the instruments and the underlying assets; risks of default by the other party to certain transactions; risks that the transactions may result in losses that partially or completely offset gains in portfolio positions; and risks that the transactions may not be liquid. Please see the fund s prospectus for additional information. 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 and frontier markets, since these countries may have relatively unstable governments and less established markets and economies. Alternative investments often are speculative and include a high degree of risk. Investors could lose all or a substantial amount of their investment. Alternative investments are suitable only for eligible, long-term investors who are willing to forgo liquidity and put capital at risk for an indefinite period of time. They may be highly illiquid and can engage in leverage and other speculative practices that may increase the volatility and risk of loss. Alternative Investments typically have higher fees than traditional investments. Investors should carefully review and consider potential risks before investing. Certain of these risks may include but are not limited to: Loss of all or a substantial portion of the investment due to leveraging, short-selling, or other speculative practices; Lack of liquidity in that there may be no secondary market for a fund; Volatility of returns; Restrictions on transferring interests in a fund; Potential lack of diversification and resulting higher risk due to concentration of trading authority when a single advisor is utilized; Absence 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 manager. As a diversified global financial services firm, Morgan Stanley Wealth Management engages in a broad spectrum of activities including financial advisory services, investment management activities, sponsoring and managing private investment funds, engaging in brokerdealer transactions and principal securities, commodities and foreign exchange transactions, research publication, and other activities. In the ordinary course of its business, Morgan Stanley Wealth Management therefore engages in activities where Morgan Stanley Wealth Management s interests may conflict with the interests of its clients, including the private investment funds it manages. Morgan Stanley Wealth Management can give no assurance that conflicts of interest will be resolved in favor of its clients or any such fund. All expressions of opinion are subject to change without notice and are not intended to be a forecast of future events or results. Further, opinions regarding Alternative Investments expressed herein may differ from the opinions expressed by Morgan Stanley Wealth Management and/or other businesses/affiliates of Morgan Stanley Wealth Management. This is not a "research report" as defined by NASD Conduct Rule 2711 and was not prepared by the Research Departments of Morgan Stanley Smith Barney LLC or Morgan Stanley & Co. LLC or its affiliates. Certain information contained herein may constitute forward-looking statements. Due to various risks and uncertainties, actual events, results or the performance of a fund may differ materially from those reflected or contemplated in such forward-looking statements. Clients should carefully consider the investment objectives, risks, charges, and expenses of a fund before investing. Interests in alternative investment products are offered pursuant to the terms of the applicable offering Page 25

26 Risk Considerations memorandum, are distributed by Morgan Stanley Smith Barney LLC and certain of its affiliates, and (1) are not FDIC-insured, (2) are not deposits or other obligations of Morgan Stanley or any of its affiliates, (3) are not guaranteed by Morgan Stanley and its affiliates, and (4) involve investment risks, including possible loss of principal. Morgan Stanley Smith Barney LLC is a registered broker-dealer, not a bank. In Consulting Group s advisory programs, alternative investments are limited to US-registered mutual funds, separate account strategies and exchange-traded funds (ETFs) that seek to pursue alternative investment strategies or returns utilizing publicly traded securities. Investment products in this category may employ various investment strategies and techniques for both hedging and more speculative purposes such as short-selling, leverage, derivatives and options, which can increase volatility and the risk of investment loss. Alternative investments are not suitable for all investors. As a diversified global financial services firm, Morgan Stanley Wealth Management engages in a broad spectrum of activities including financial advisory services, investment management activities, sponsoring and managing private investment funds, engaging in broker-dealer transactions and principal securities, commodities and foreign exchange transactions, research publication, and other activities. In the ordinary course of its business, Morgan Stanley Wealth Management therefore engages in activities where Morgan Stanley Wealth Management s interests may conflict with the interests of its clients, including the private investment funds it manages. Morgan Stanley Wealth Management can give no assurance that conflicts of interest will be resolved in favor of its clients or any such fund. Alternative investments involve complex tax structures, tax inefficient investing, and delays in distributing important tax information. Individual funds have specific risks related to their investment programs that will vary from fund to fund. Clients should consult their own tax and legal advisors as Morgan Stanley Wealth Management does not provide tax or legal advice. 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). Also, municipal bonds acquired in the secondary market at a discount may be subject to the market discount tax provisions, and therefore could give rise to taxable income. Typically, state tax-exemption applies if securities are issued within one s state of residence and, if applicable, local taxexemption applies if securities are issued within one s city of residence. The tax-exempt status of municipal securities may be changed by legislative process, which could affect their value and marketability. 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. Asset-backed securities generally decrease in value as a result of interest rate increases, but may benefit less than other fixed-income securities from declining interest rates, principally because of prepayments. Credit ratings are subject to change. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. These risks are magnified in frontier markets. 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. 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. Investing in smaller companies involves greater risks than those associated with investing in more established companies, including 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. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Companies paying dividends can reduce or cut payouts at any time. Companies paying dividends can reduce or cut payouts at any time. Nondiversification: For a portfolio that holds a concentrated or limited number of securities, a decline in the value of these investments would cause the portfolio s overall value to decline to a greater degree than a less concentrated portfolio. Portfolios that invest a large percentage of assets in only one industry sector (or in only a few sectors) are more vulnerable to price fluctuation than those that diversify among a broad range of sectors. Page 26