Morgan Stanley Investment Funds Diversified Alpha Plus Low Volatility Fund

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1 Investment management COMMENTARY DATA AS OF June 30, 2016 Morgan Stanley Investment Funds Diversified Alpha Plus Low Volatility Fund FOR PROFESSIONAL CLIENTS ONLY. PERFORMANCE REVIEW In the month of June 2016 the fund s Z shares returned -2.35% (net of fees). During the month, the MSCI All Country World Index returned -1.0% in local currency terms (-0.4% EUR), and the JP Morgan Global Government Bond Index returned +2.4% in local currency terms (+3.8% EUR). Commodities rose +0.1% in USD terms and +0.3% in EUR (S&P GSCI Total Return Index). In June, risk off market activity leading up to and following the Brexit vote hurt our Europerelated positions, including a long position in European domestic stocks vs. U.S. equities, long positions in the Swedish krona, and a directional short in German 10-year Bunds. Our Long Value / Short Expensive Quality theme also detracted amid the flight to safety (short U.S. 10- year Treasuries; long U.S. banks and consumer finance stocks; short U.S. apartment REITs and staples stocks). Offsetting this somewhat were gains from our hedged short position in German vs. U.S. 10-year rates, hedged longs in global gold miners and U.S. pharmaceutical stocks, and shorts in the Chinese renminbi. Fund launch April 2014 Investment team Cyril Moullé-Berteaux, Sergei Parmenov Location New York Base currency Euro MARKET REVIEW Volatility spiked in June, peaking as the UK voted to exit the European Union on June 23rd. The market sold off sharply following the referendum; however, dovish rhetoric from central bankers helped calm markets in the last few days of the month, and global equities rallied +4.7% to finish the month down -1.0% in local terms (MSCI ACWI). Emerging markets and the U.S. led, closing in positive territory, while a +7.3% rally in the yen weighed on Japan (TOPIX down -9.6%). The Euro Stoxx 50 Index was down -6.2%. Utilities and energy were the top performing sectors globally, while financials and consumer discretionary were the hardest hit. In contrast to the equity market reversal, bond yields remained lower through month end, with UK and German yields closing at all-time lows (10-year Gilt yields fell -56 bps to 0.87%, and 10-year Bund yields fell -27 bps to -0.13%). U.S. 10-year Treasury yields fell to their lowest level in three years, as rate hike expectations were pushed out further. The market is now pricing in zero chance of a hike in 2016 (vs. a 100% chance at the end of May), and the next Fed hike is not fully priced in until January The flight to safety also lifted gold, up +8.8%. The U.S. dollar sold off early in June as the labor market continued to tighten, but rallied post-brexit to finish the month flat. The British pound fell -8.2% vs. the U.S. dollar, reaching a 31-year low. The top-performing currency was the Brazilian real, up +12.4% against the dollar, as Brazil s senate approved a new central bank president. PORTFOLIO ACTIVITY During June, we brought the portfolio s beta to neutral ahead of the UK referendum, bringing our net global equity exposure to -1% at month end, compared to -10% at the end of May.

2 Following the UK s vote to exit the European Union, we reduced directional short positions in German and U.S. 10-year rates, having hit our stops, and booked profits on our short position in the Swiss franc vs. the euro, our hedged short in luxury stocks and our hedged long in gold miners. We initiated a long position in European airlines vs. global equities, as we believe the current record-low valuations relative to global equities are overstating the impact of Brexit on business travel to the UK and Europe. Within our China slowdown theme, we initiated a short position in the Chinese renminbi vs. a trade-weighted basket of currencies, as we continue to believe renminbi devaluation will be necessary to address China s structural and economic issues. We were stopped out of our short positions in Asian currencies vs. the U.S. dollar, euro and sterling following Brexit, and we closed our long position in New Zealand vs. German 10-year rates, as New Zealand s central bank appeared less dovish than we expected at its June meeting. We initiated a short position in U.S. apartment REITs vs. U.S. REITs, as we continue to expect an oversupply of apartments to result in earnings declines in , vs. consensus expectations for 5-7% earnings growth. We added to our long positions in Argentine assets (USD-denominated 10-year bonds, and FX), and our short position in U.S. media stocks vs. U.S. equities. We closed hedged longs in U.S. banks and consumer finance stocks, having hit our stops. STRATEGY AND OUTLOOK Over the past several quarters, a persistent wave of new shocks has seemingly derailed every incipient stabilisation in global growth: 2015 saw the Greek referendum, Russian sanctions and Chinese devaluations. Earlier this year, we saw a second Chinese devaluation and a collapse in oil prices to decade-plus lows. Finally, in June, just as growth was beginning to recover from these various hits, Brexit occurred, triggering fears of contagion throughout Europe. Our view is that Brexit will indeed likely snuff out what looked like a small pickup in global activity, though we expect much of the pain to be concentrated in the UK and to a smaller extent Europe. As a result, we expect global growth to hover in borderline recessionary territory over the next twelve months (i.e., slightly below 2%, taking into account the Conference Board s adjusted figures designed to estimate a true China GDP), implying roughly zero global profits growth. We detail our forecasts for the global growth outlook, as well as potential implications for global financial markets, below. We believe that Brexit will likely lead to a UK recession over the next 12 months, due to the uncertainty created by the renegotiation of trade agreements with the European Union and other trading partners, including the likely loss of EU passporting rights for the UK financial services sector. It is unclear how onerous a new EU trade deal might be to UK growth, as maintaining similar access to the EU market would likely require immigration guarantees that are not acceptable to the Conservative government. Until these issues are resolved, we believe they will create a significant disincentive for businesses to invest in the UK, ultimately impacting capital spending, employment and consumer spending. As a result, we expect UK growth to slow from 2.0% year-over-year in 1Q to 0% over the next twelve months. We also expect Brexit to trigger a slowdown in the Eurozone, albeit more modest than in the UK. Given the weak sterling and our expectations for weak UK consumption, we expect Eurozone exports to the UK to fall by roughly 10%, taking 25 bps off Eurozone GDP. In addition, we believe that political and economic uncertainty regarding the Eurozone s future (which we detail below) will result in a slowdown in capital expenditures, shaving an additional 25 bps off GDP growth. In total, we expect Eurozone

3 GDP growth to fall by 50 bps, from 1.6% year-over-year in 1Q 2016 to 1.1% over the next four quarters (with much of the impact occurring in the second half of this year). In addition to Brexit s initial impact on Eurozone growth via exports, we expect the referendum to bring a renewed focus on Europe s unresolved structural problems. The Italian banking system remains at the forefront of potential concerns. Due to questions over non-performing loan (NPL) provisioning and inadequate capital, Italian bank stocks are down roughly 50% year-to-date and are nearing their 2012 peripheral crisis lows. Arguably every major Italian bank would need additional capital if all NPLs were marked to their estimated market clearing prices, and such an immediate cleanup would probably cost about billion. There has been speculation that this type of full cleanup of the banking system is currently being negotiated. However, the larger banks, in particular, believe that they will be able to adequately manage NPLs and capital requirements with current profits and/or asset sales, and we believe it is becoming increasingly likely that Italian authorities will just continue to focus on smaller, more impaired banks for now (to the consternation of the market). Another looming threat to the Eurozone is the rise of Euro-skeptic political parties, whose popularity may be boosted by the British referendum. Dissatisfaction with the European Union is particularly high in Italy and France, and we are seeing a rise in left and right wing populist parties across most EU nations. Perhaps of most immediate concern, Italy is scheduled to hold a constitutional referendum on the reform of its electoral process by late October or early November. If Prime Minister Renzi loses the referendum, he has promised to resign, and political instability will likely follow (along with a loss of reform momentum). A new election could very well bring the anti-establishment Five Star Movement (5SM) party into power (the election could occur in 2017, and has to occur by 2018). While 5SM has recently backed away from previous calls for a European Union referendum, popular skepticism of the EU is high in Italy, and 5SM could move to exploit this anti-euro sentiment. These political and structural risks suggest additional risk premia for European assets (i.e., lower multiples and higher credit spreads). For Eurozone equities (measured by the MSCI Euro Index), we estimate that a 20% discount on forward price-to-earnings multiples relative to U.S. equity valuations would be appropriate, rather than the typical discount of 15% that we have seen over the last 15 years. That being said, for all the concern about Brexit, we do believe that its economic impact will be concentrated in the UK and Europe. We expect the U.S. to be relatively unaffected: any change in U.S. exports to the UK should have a low impact on growth, and the tightening effects of a slightly stronger dollar should be largely offset by lower bond yields and mortgage rates. We thus expect U.S. domestic activity to remain resilient, with GDP growth falling by about 10 bps to 2.0% over the next twelve months (assuming % consumption growth, with some drag from net exports due the lagged effect of USD strength). We also expect emerging market (EM) growth to be generally unaffected by the Brexit. However, Chinese manufacturing activity continues to ebb, and we remain concerned that a further slowdown in Chinese growth is already beginning. China s massive stimulus efforts appear to have created a one-quarter pop in activity, which we believe is already relapsing as the credit impulse declines due to regulatory crackdowns on shadow banking. Given the recent slowdown in credit growth, we forecast that Chinese growth will slow to 2.7% over the next twelve months, from 3.5% year-over-year in the first quarter (based on the Conference Board s adjusted China GDP data). That being said, we expect growth in the rest of EM to improve as Brazil and Russia come out of recessions. Net-net, as China slows (weighing on export-sensitive EM economies) while Brazil and Russia rebound, we expect overall EM growth to pick up slightly to 2.9% over the next twelve months, from

4 2.8% in 1Q Thus, taking into account our forecasts for economic growth across major regions, we expect global growth to be about 1.85% over the next twelve months, slightly down from growth of 2.0% year-over-year during 1Q, with developed market growth slowing from 1.7% currently to 1.4% over the next twelve months, and emerging market growth picking up from 2.8% to 2.9%. As we estimate global trend growth at 2.5%, we consider 2% growth to indicate a borderline global recession. We believe that the implications for global financial markets are as follows: on the bearish side, we anticipate global profits growth of around 0%, with earnings growth of +3% in the U.S., +2% in the Eurozone, -2% in Japan and -3% in emerging markets. On the bullish side, we expect more central bank easing and lower-for-longer bond yields. In the next quarter, we expect the Bank of England to cut rates. The European Central Bank is also likely to ease, but mostly via quantitative easing (QE), as negative rates are hurting Eurozone banks. We expect the Bank of Japan to ease and increase QE, coupled with fiscal stimulus (though with questionable effectiveness). Perhaps most importantly, we expect the U.S. Federal Reserve to delay its next rate hike until late 2016 or early We believe that an easier Fed will mean a stable dollar, which is good for emerging economies. As U.S. dollar liquidity is arguably the most important supporter of global financial markets, we expect that equity valuations will continue to be supported despite global growth at a stall speed and profits at 0%. Net-net, we believe that global equities are likely to be range-bound in the coming quarters. Zero profits growth over the next twelve months will likely be insufficient to support a bull market, particularly considering the unresolved downside risks due to the Eurozone periphery and China, as well as the current cycle-high equity valuations. However, unless global profits shrink by 5-10% as they did in 2015, or the Fed tightens, we see no major near-term impulse for a renewed bear market either. We caveat this by noting that, over the next twelve months, we believe it will be difficult for the Fed to continue to put off rate hikes if Europe heals and China manages to avoid a further slowdown. On the flip side, if Europe is hit with another political, economic or banking issue, or if China slows more rapidly than we expect, global profits will likely shrink and traditional monetary policy easing will likely be insufficient prevent a further slowing of global growth. In conclusion, while we believe it is possible to experience a few more quarters of Goldilocks amid sluggish though not quite recessionary global growth, we believe that either noticeable improvement or deterioration in the global growth outlook could have negative implications for equity markets (either via Fed tightening or profits shrinking, respectively), thus creating more downside risks than upside opportunities at this time. As a result, we remain cautious on global equities, particularly with many markets rebounding to or even exceeding their pre-brexit price levels. We also believe that government bonds are too expensive to own, with yields significantly below inflation and pricing in no rate hikes for multiple years. Thus, we are continuing to hunt for idiosyncratic opportunities that are uncorrelated with broad equity and fixed income market activity; we also maintain exposures within our China slowdown theme, with an emphasis on our expectations for renminbi devaluation and a further commodity slowdown as credit growth slows. For further information, please contact your Morgan Stanley representative.

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