Dealing with Today s Markets Fixed Income Strategy Portfolio Strategy & Research Group

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1 THE SPINA GROUP AT MORGAN STANLEY SMITH BARNEY ROBERT D. SPINA Senior Vice President Financial Advisor Portfolio Manager (516) NANCY A. BOHAN First Vice President Financial Advisor Portfolio Management Director (516) Dealing with Today s Markets Fixed Income Strategy Portfolio Strategy & Research Group MSSB North America - Morgan Stanley Smith Barney LLC Groundhog Day 100 Jericho Quadrangle Jericho, NY (800) Fax (516) KARIN NONNENMANN Registered Marketing Associate (516) KARIN.NONNENMANN@MSSB.COM PATRICIA WATKINS Client Service Associate (516) PATRICIA.WATKINS@MSSB.COM Kevin Flanagan Chief Fixed Income Strategist Managing Director Kevin.Flanagan@mssb.com Given today's action by the Fed, quotes from Chubby Checker (The Twist/Let's Twist Again), the Isley Brothers/Beatles (Twist and Shout) or Sam Cooke (Twistin' the Night Away) could have been used in the title. However, when one looks forward from a money and bond market perspective, the movie, Groundhog Day, seems more appropriate, with investors playing the lead role of Phil Connors (Bill Murray). Indeed, don't you get the feeling, we've been down this road before? In 2009, the Fed gave us QE1 (worth in total $1.75 trillion), QE2 and the reinvestment program in 2010 (worth $850 to $900 billion), and now in 2011, Operation Twist/Torque, et al. (worth $400 billion). The one real 'twist' in the announcement is now that the Fed will be reinvesting their principal payments from agency and agencybacked MBS into the agency-backed MBS market, rather than Treasuries, as is currently the case. As we've mentioned before, in our opinion, these operations have a law of diminishing returns, perhaps a reason why the FOMC also implements lower totals with each new stimulus measure as well. Here's some quick thoughts following today's latest move from the US monetary policymakers: According to Chairman Bernanke, the Fed has these remaining 'arrows in the quiver': reducing the IOER from its current 0.25% level; providing even more guidance for the fed funds outlook, such as 'fed funds will remain at its current low level until the unemployment rate drops to a certain level and/or inflation moves up to a certain level'; finally, a 'true QE3' where the Fed expands its balance sheet from current levels. Note, this latest policy from the Fed does not do this. October 2011 Volume IX

2 Back to the "Groundhog Day" concept: - If history is any guide, Fed purchases of UST securities does not necessarily mean interest rates can't go up. In fact, consider the following: 1) Leading up to the original QE1 announcement, which occurred at the March 2009 FOMC meeting, the UST 10-yr yield dropped to a low of 2.06% in December By June 2009, the 10-yr yield hit 3.95%, and topped out at roughly 4% in early April ) Leading up to the QE2 announcement at the November 2010 FOMC meeting, the 10-yr yield hit a low of 2.39% in October. By December 28th, the 10-yr yield rose to 3.49%, reaching its latest peak of 3.74% in February ) Here in 2011, the 'low close' for the 10-yr was 1.92% (1.85% is resistance) stay tuned. - Our bottom line message is that there are other more important factors besides Fed purchases which determine where UST rates could be headed, such as the economic/inflation outlook, flight-to-quality issues stemming from the Euro Zone or the equity markets, and fund flows into other assets like corporate bonds. All of these same issues are still with us and will most likely remain an integral part of the investment landscape for 2012 as well. The one notable difference between the 2012 outlook and the prior two years is that we now know the Fed will not be entertaining any exit strategies or rate hikes. - Fiscally speaking, it seems likely the stimulus measures employed for this year (payroll tax cuts, extending unemployment benefits, accelerated depreciation for business investment) could be 'reupped' for If this does come to fruition, it would seem likely that fears of a 'double-dip' would recede, accordingly. In fact, like we have witnessed in the prior two years, inflation anxieties could come back into vogue. - In the Euro Zone, conventional wisdom holds that Greece will get their next bailout package and that the majority of member countries will approve an expansion of the EFSF facility. Such an outcome could very well place the 'Euro Zone' headlines to the back burner for awhile, but make no mistake, this issue will rear its ugly ahead yet again. - Against this backdrop, the UST market could very well turn the page as it did in 2009, 2010 and 2011, with 10-yr yields actually rising again. However, we seem to be in a pattern of producing 'lower highs' (and 'lower lows' for that matter). In this type of an environment, any potential rise in the 10-yr yield could be capped out somewhere between 3% and 3.50%. The safety bid for Treasuries has remained a dominant force since the beginning of August. From June 1st through August 1st of this year, the UST 10-yr traded between 2.75% and 3.25%, no doubt reflecting the slowdown in domestic economic conditions and the prospect for additional Fed policy action. The subsequent drop to 2%, and below, was primarily a function of two things. The first was the plunge in confidence stemming from the debt ceiling showdown and US downgrade, and the other key factor being a worsening in conditions within the Euro Zone. Recent history has told us that if the situation in Europe were to subside to some degree, the reversal of the safety trade can be a swift one, but as the aforementioned range shows, rates in general would still be historically low. In addition, if history (Groundhog Day) does repeat itself, stubbornly high unemployment and lackluster economic growth will be the norm, Euro Zone challenges will remain, if not escalate, and safety will become of paramount importance to investors. Obviously, this would most likely take UST 10-yr yields lower from the potential 3% to 3.50% range, which in turn, would make any back-up in rates, a buying opportunity. October

3 Retirees: Beware the Budget Ax September 2011 Legislation to balance the federal budget may end up cutting many retirement benefits, and Financial Advisors should help clients prepare for the unknowns, says Invesco s Kathryn Capage The debt and deficit debate in Washington has retirement specialists like Kathryn Capage, director of retirement research with Invesco, worrying that future generations of retirees will be less able to fund their post-work years. A bipartisan super committee of 12 lawmakers is tasked with trimming $1.5 trillion of federal spending by November, and President Obama may seek even deeper cuts, according to Bloomberg. Capage s concern: We are worried that some of the tax advantages of deferred compensation plans may go away, she says. * There are two competing forces at work, Capage says. First is the seismic demographic event involving the baby boomers: Some 78 million of them are expected to retire in the next two decades, according to the U.S. Census Bureau. At the same time, the debt-ceiling deal compels lawmakers to make cuts in benefits programs. With little appetite for raising income-tax rates, Capage believes Congress may decide to do away with some tax perks instead. And one of the biggest can be found in the tax deductions given to 401(k) plans and individual retirement account contributions. Together these will account for about $141 billion of untaxed money by 2014, according to the Joint Committee on Taxation. Capage points out that the total amount of tax-free money that can be deposited in a defined contribution plan could drop to $20,000 a year from $49,000 if the super committee adopts the recommendations of the National Commission on Fiscal Reform and Responsibility. Social Security is also vulnerable, Capage believes. One proposal calls for switching to the chain-weighted consumer price index to calculate Social Security s cost-of-living increases. Unlike the current CPI, the chain-weighted CPI takes into account the changes people make in their lives when prices rise. For example, the thinking goes, if the price of beef goes up, some people may switch to poultry, which is less expensive. The result, say those who favor this approach, is that prices therefore do not increase as much as the regular CPI would suggest so Social Security benefits do not need to rise as much each year. Another proposal would gradually shift the normal retirement age to 69 from 66 for those born after More troubling, Capage believes, is the cuts that could befall Medicare, since that program is in worse fiscal health than Social Security. A couple who earned $113,000 in wages and will retire in 2011 will have paid $781,000 in Social Security taxes and is expected to receive $672,000 during the course of their retirement, according to estimates from the Urban Institute. Medicare s economics stack up very differently, the Urban Institute finds. The same couple will have paid $154,000 into that program but is likely to receive $357,000 in Medicare benefits. The new health-care reform act should help to shore up Medicare with new taxes on high earners beginning in 2013, Capage says, but this doesn t eliminate the underfunding entirely. It s still unclear what types of cuts the super committee might adopt, but if Congress takes no action, the debt-ceiling compromise calls for an automatic 2% cut to Medicare. October

4 Financial Advisors preparing their clients for retirement face a difficult challenge given these unknowns, Capage says. She recommends preparing for several scenarios. People should be diversified across their retirement assets, she says. Capage recommends a combination of 401(k) assets, IRAs and even non-qualified accounts because she anticipates that tax rates on capital gains will stay low. Saving is more important than ever, she says. You want to make sure that [clients] have enough in retirement assets so that the words Social Security aren t that important to [them]. Capage also urges FAs to help their clients purchase the best medical coverage they can afford, given the uncertainty surrounding Medicare. Ideally, retirees shouldn t rely on Medicare for the bulk of their health-care needs, she says. And jogging, quitting smoking and staying healthy isn t bad advice either. *The opinions expressed are those of the Katherine Capage as of Aug. 2, 2011, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. The guest speaker is neither an employee nor affiliated with Morgan Stanley Smith Barney. Opinions expressed are solely those of the speakers and do not necessarily reflect those of Morgan Stanley Smith Barney. Individuals should consult with their tax/legal advisors before making any tax/legal-related investment decisions as Morgan Stanley Smith Barney and its Financial Advisors do not provide tax/legal advice Tax laws are complex and subject to change. MSSB, its affiliates and MSSB Financial Advisors do not provide tax or legal advice. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their personal tax or legal advisors to understand the tax and related consequences of any actions or investments described herein. The views and opinions expressed herein do not necessarily reflect those of MSSB. The information and figures contained herein has been obtained from sources outside of MSSB and MSSB makes no representations or guarantees as to the accuracy or completeness of information or data from sources outside of MSSB. MSSB is not responsible for the information, data contained in this document. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. The material has been prepared for informational or illustrative purposes only and is not an offer or recommendation to buy, hold or sell or a solicitation of any offer to buy or sell any security, sector or other financial instrument, or to participate in any trading strategy. It has been prepared without regard to the individual financial circumstances and objectives of individual investors. Any securities discussed in this report 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. There is no guarantee that the security transactions or holdings discussed will be profitable. This material is not a product of Morgan Stanley & Co. Incorporated's or CitiGroup Global Markets Inc.'s Research Departments or a research report, but it may refer to material from a research analyst or a research report. The material may also refer to the opinions of independent third party sources who are neither employees nor affiliated with MSSB. Opinions expressed by a third party source are solely his/her own and do not necessarily reflect those of MSSB. Furthermore, this material contains forwardlooking statements and there can be no guarantee that they will come to pass. They are current as of the date of content and are subject to change without notice. Any historical data discussed represents past performance and does not guarantee comparable future results Morgan Stanley Smith Barney LLC. Member SIPC October

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6 IMPORTANT INFORMATION REGARDING YOUR NEW CHECKS As we continue to integrate the services and platforms of Morgan Stanley and Smith Barney, we are making some important changes to our check program. You will have a New Checking Account Number and a New Routing (ABA) Number: Both your old checking account numbers and new checking account numbers will be displayed on the first page of your check packets. Your new checking account number and routing number will be located on the bottom of your new checks. Important: You should update any standing instructions 1 with your new checking account number and routing number as soon as possible. These standing instructions may include items such as direct deposit of Social Security or payroll and/or the automatic debit of a mortgage payment, auto loan payment, insurance premiums or other payments. Please note You may begin using these new checks immediately: We recommend that you destroy any remaining old checks and begin using your new checks immediately. Outstanding checks and existing standing transactions for direct deposits or debits will continue to be honored through December These standing instructions are also known as Automatic Clearing House (ACH) instructions. October