A Political Economy. Global Cross-Asset Strategy Cross-Asset Navigator. Global

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1 Global Cross-Asset Strategy Team Morgan Stanley & Co. LLC Morgan Stanley & Co. International plc+ Morgan Stanley Australia Limited+ Morgan Stanley & Co. LLC Gregory Peters H Neil McLeish H +44 (0) Gerard Minack H Jason Draho Global Global Cross-Asset Strategy A Political Economy Asset Class Views (12 months) Base case: Defensive strategic positioning based on slowing global growth and deleveraging tail risks We expect 2012 to be a year driven by political events and policy risks. It s a new year, but unfortunately policy risks are likely to create the same, if not more, headwinds for global financial markets. Indeed, policy risk was responsible for much of the elevated uncertainty over the past six months, and that has led to higher volatility across all asset classes. The US is likely to be the dominant election story in 2012, but it is far from the only policy risk. Seven of the G20 countries will be holding elections in 2012, each being a source of uncertainty. In addition, investors will be watching closely for signs of progress on fiscal integration in the Eurozone. In the US, both economic policy uncertainty and political polarization are at all time highs. Amidst this uncertainty, the US faces an unprecedented 4.5% fiscal drag in 2013 without a change in the current policy. Thus, how the US election plays out could have a significant impact on the growth outlook for 2013 and beyond. We present US election result scenarios and their potential impact on policy. However, the markets are likely to price in these scenarios before the election. Regardless of fiscal progress, major policy mistakes particularly in the first half of 2012 could topple risk markets. Four charts: 1) Year-end S&P 500 price target forecast; 2) Diverging real rates and inflation expectations; 3) USD to remain strong in 2012; and 4) US to follow a path of slowing growth (page 7). USD JPY Gold US credit Europe credit EM equities EM currencies EM credit US Treasuries German Bunds Europe equities Oil Commodities US Equities EM rates Japan equities GBP EUR 2012 Page Global Cross-Asset Strategy Overview 2 A Political Economy 3 Global Cross-Asset Chart Corner 7 + Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. += Analysts employed by non-u.s. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

2 Global Cross-Asset Strategy Overview Base Case (12-month view) On a long-term strategic perspective, we are bearish on developed market equities, while bullish on emerging market assets. DM is in a multi-year deleveraging cycle fraught with numerous negative feedback loops, and faces a long, difficult road to economic recovery as a result. In contrast, the strong secular fundamentals for EM economies should continue. Our base case is slowing global growth, and divergence between anemic DM and solid EM. Our economists forecast global growth of 3.5% in 2012, with EM at 5.7% and DM at 1.2%. European recession is our base case; US and EM recession is in the bear scenario. Risks are to the downside on constrained policy and potential fiscal tightening. Sovereign risk should gradually ease as the Eurozone makes progress towards a fiscal union. However, the tail risk of a disorderly break-up of the Euro remains, as the process is likely to be protracted and uneven. The ECB is more aggressive and accommodative under President Draghi, and is likely to provide a bridge to the final fiscal and institutional solution by aggressively back-stopping sovereign bonds. The EM outlook should improve in 2H12, with increased regional differentiation. EM growth is slowing and EM CEEMEA specifically is vulnerable to deleveraging by EU banks. However, funding market stress should ease as the year goes on and the growth outlook should improve as central banks lower rates. China is key; it should soft land, but it doesn t have the same policy flexibility as in 2008 to spur growth. Risks look binary and skewed to the downside, and high volatility will require investors to be nimble. With investors continuing to trade on policy and politics, the markets are likely to remain tactically oriented and range bound. The tactical rally could continue into the New Year on ECB easing, but growth and fiscal challenges remain. Asset Class Views We favor a defensive strategic positioning on a 12-month view. In DM, we favor credit over government bonds and equities. Defensive assets (USD, JPY, gold) are attractive due to the many macro risks. 2H12 looks better for EM assets as funding stress falls and growth rises. Poor liquidity increases the flexibility value of holding cash. Constructive on credit. 1-2% growth can be positive for credit, as it ensures conservatism. Ongoing deleveraging, strong corporate fundamentals, and relatively cheap valuations are also supportive. Poor liquidity and high volatility are challenges. UW DM equities, OW EM equities. Slow growth and deleveraging should keep DM equities range bound. Europe is very cheap and could rally on an aggressive ECB and lower tail risks. Policy easing and cheap valuations favor EM equities, especially AXJ. Neutral on government bonds. Treasuries likely stay range bound ( %) on tepid growth and potential QE3. Bunds should rally on ECB cutting, but could weaken if infected by sovereign risk. Prefer real rates on rising inflation expectations. USD, JPY strength, EUR weakness. We expect USD and JPY strength on slower growth and deleveraging stress; EUR outlook is bearish on a more dovish ECB. EM FX weighed down near term by funding stress, better 2H12 outlook on growth. Negative skew on commodities. Slowing global growth is likely to weigh on industrial metals and increased supply should keep oil under pressure. Gold remains an attractive long-term defensive play. Risk Factors / Catalysts Progress on Eurozone integration is too slow. Going from agreement on fiscal discipline to euro bonds could occur haltingly, if at all. Deleveraging is disorderly. If deleveraging occurs too quickly, markets could destabilize. If it s too slow, markets could destabilize as debt levels stay high. Fiscal tightening slows US growth. Growth of 2% in 2012 is at risk if fiscal stimulus isn t extended; falling below stall speed increases recession risk. EM impaired by deleveraging. EM, and especially CEEMEA, bears a disproportionate burden of EU bank deleveraging, which could be a big drag on growth. China policy constraint. Growth continues to slow in China, and thus EM, and China does not have the policy flexibility to respond sufficiently to spur growth. Upside risk: Under Draghi, the ECB is far more aggressive at supporting sovereigns and banks. Upside risk: Coordinated global monetary policy as central banks jointly ease. Upside risk: A breakthrough on the US budget, with increased stimulus and long-term budget cuts. Relative Preferences + USD JPY Gold US credit Europe credit EM equities EM currencies EM credit US Treasuries German Bunds Europe equities Oil Commodities US Equities EM rates Japan equities GBP EUR

3 A Political Economy We expect 2012 to be a year driven by policy and political events, with seven of the G20 countries holding significant elections. In the US, both economic policy uncertainty and political polarization are at all time highs. Needless to say, this is a toxic combination. Amidst this uncertainty and the looming unprecedented 4.5% fiscal drag in 2013, we present US election result scenarios and their potential impact on policy. Regardless of fiscal progress, major policy mistakes particularly in the first half of 2012 could topple risk markets. It s a new year, but unfortunately policy risks are likely to create the same, if not more, headwinds for global financial markets. Global policy and political event risks dominated 2011, leading to destabilizing policy errors and keeping the markets on edge. Front and center last year were the policy errors in the Eurozone as investors waited for belated policy actions, but were often met with vague announcements and ineffective or counterproductive actions such as levering the EFSF and Greek PSI (private sector involvement) to name just a couple. In the US, political gridlock prevented a substantive agreement on cutting the deficit, and was a primary contributor to the downgrade of the country s debt rating. Perhaps we are overly pessimistic, but to us there is little reason to believe that policy and the consequent errors will be any less prevalent in While the US will likely be the dominant election story in 2012, it is far from the only policy risk, election or otherwise. Seven of the G20 countries will be holding elections in 2012, including France, Mexico and Russia, as well as the change in China s leadership. Each of these is likely to perpetuate uncertainty and potentially fuel even higher politically induced volatility across the globe than we experienced in Beyond elections, Exhibit 1 lists a number of other policy events that have the potential to be disruptive. Like 2011, this includes central bank meetings, as investors expect the Fed and ECB to ease policy. Also on tap are a series of meetings in Europe that will provide a forum to address the debt crisis. Whether or not they will produce progress this year towards a fiscal union in the EU is debatable. But that s all the more reason why these meetings will be in the market s spotlight as the outcome could go either way. That captures the binary nature of policy risks generally, which is why these events can have such an effect on the markets. Exhibit 1 Potential 2012 Policy Event Risks Date Event January 1, 2012 Basel 2.5 to be adopted by all members January 12, 2012 ECB Council Meeting & Press Conference January FOMC Meeting February 19, 2012 Greece election March 1-2 EU Summit March 1, 2012 NPC meeting in China March 1, 2012 CPPCC meeting in China March 8, 2012 ECB Council Meeting & Press Conference March 13, 2012 FOMC Meeting April 22 & May 6 Presidential elections in France May 25, 2012 EU Summit June 10 & June 17 Legislative election in France June 30, 2012 Deadline for EU banks to meet EBA requirements July 1, 2012 India Presidential Elections July 21, 2012 US Dodd-Frank and Volcker rules implemented August 27, 2012 US Republican Party Presidential Nomination October 1, 2012 China Communist Party Internal Leadership Elections October EU Summit November 6, 2012 US Presidential and Legislative Elections December EU Summit December 15, 2012 US begins reviews for next round of bank stress tests Source: Morgan Stanley Research Indeed, policy risk was responsible for much of the elevated uncertainty over the past six months, and that has led to higher volatility across all asset classes. Looking at specific policy events in 2H11, we examined some of the largest intraday market moves in the S&P 500 and the 2-year Treasury yield. Politics and policy shocks resulted in large discrete price moves in both assets, and that led to higher overall volatility (Exhibit 2). By comparison, in 1H11 the largest intraday market moves were smaller and driven mainly by economic data releases. This provides a rough benchmark for how markets could respond to macro shocks in

4 Exhibit 2 1-Day Price Moves Associated With Policy Events in 2011 Equity Markets (S&P 500) Date Move Event 8 Aug S&P downgrades US from AAA to AA+ on Aug 5 4 Aug Aug Fed announces it will keep rates exceptionally low through 2013 Fixed Income Market (2Y bond yield) Date Move Event 8 Jun US payroll numbers are weak and unemployment rate increases 9 Aug Fed announces it will keep rates exceptionally low through May Greece rejects proposed austerity measures 4 Aug US debt ceiling agreement disappoints US debt ceiling agreement disappoints in Japan and the fall in gasoline prices in 2H11 relative to 1H11 that provided a boost to consumer spending. Looking beyond the very near term to the rest of 2012 and especially 2013, the risk is that policy errors could lead to a more pronounced slowdown. Even without policy errors, which unfortunately seem likely, the sheer uncertainty over how fiscal and regulatory policy on taxes and spending could evolve is a weight on the markets, adding to risk premiums. In fact, an index created by professors at the University of Chicago and Stanford University suggests that US policy uncertainty is at a generational high, peaking last summer around the debt ceiling debate (Exhibit 3). The index defines policy uncertainty using dispersion of economic forecasts, news mentions of uncertainty, and pending expiration of tax legislation. The rise in the index seems to mirror the more anecdotal view that investors are increasingly uncertain about the policy environment. Exhibit 3 US Policy-Related Economic Uncertainty Is at an All Time High 350 Source: Bloomberg, Haver, Morgan Stanley Research 300 How the US election plays out could have a significant impact on the growth outlook for 2012 and beyond. The Iowa Republican primary yesterday was the opening step in the US presidential election. It s too soon to say who will be the eventual nominee, but it is still possible to make general inferences about the economic implications that could occur, both in terms of actual policy and the uncertainty created as policies remain unresolved. With the US economy showing increasing strength, potential fiscal and monetary potholes stemming from the election and potential policy uncertainty could alter the growth trajectory quite significantly. Of US Political Polarization and Potholes Just how relevant policy is to the US growth outlook was demonstrated by the debate over extending the payroll tax cuts and unemployment benefits. The best Congress could agree on was a two-month extension starting January 1 that avoided, for the time being, fiscal tightening of about 1% in Even with this stopgap measure, which is likely to be extended throughout all of 2012 before the end of February, our US economics team expects GDP growth to slow to 2.2% in 1Q12, from 3.2% in 4Q11. The slowdown is due to a number of special factors ending, including the bounce-back from the supply-chain disruptions stemming from the tsunami Source: Baker, Bloom and Davis (2011), Measuring Economic Policy Uncertainty. University of Chicago working paper. Note: The index averages several components that reflect the frequency of news media references to economic policy uncertainty, the number of federal tax code provisions set to expire in future years, and the extent of forecaster disagreement over future inflation and federal government purchases. This rise in policy uncertainty is likely due to many factors, including the debt crisis in Europe, a housing market that continues to weaken, and the aftermath of the financial crisis, the onset of which coincided with the initial rise in uncertainty. But perhaps the biggest factor is the inability thus far of politicians in Washington to tackle in any significant way the economic and fiscal problems in the US. This gridlock in Congress is not surprising, considering that the polarization between Democrats and Republicans has become extreme over the past 40 years. As Exhibit 4 shows, there s now very little overlap between the two parties in voting patterns. The difference in views makes reaching 4

5 agreement that much harder on any significant fiscal reform on tax policy and spending cuts. Exhibit 4 Increasing Congressional Party Polarization 90 th Congress Party Voting Overlap ( ) Density Democrat Republican Liberal Conservative 100 th Congress Party Voting Overlap ( ) Density Democrat Republican Liberal Conservative 110 th Congress Party Voting Overlap ( ) 2.0 Density $1.2 trillion in automatic spending cuts would start next year. Based on current law, the total amount of fiscal drag in 2013 would be almost 4.5% of GDP (Exhibit 5), an amount far in excess of any tightening in recent decades and almost certainly enough to push the US economy into recession. The likelihood that this amount of fiscal tightening occurs seems quite low gridlock may be leading to policy footdragging, but self-preservation suggests that politicians will pass legislation that reduces this fiscal drag. Indeed, our US economists forecast that the actual drag will be much less than 4.5%, more like %. Yet this amount is still not insignificant, and is one of the reasons they forecast US growth to slow in 2013 relative to 2012, from 2.2% to 1.7%. This stands in contrast with the current consensus view among other economists, which has US growth picking up from 2.1% in 2012 to 2.5% in 2013 (Exhibit 6). Exhibit 5 Potential Fiscal Drag of 4.5% in Current Policy 3 Fiscal Restraint MS Assumption Fiscal Stimulus Democrat Republican Source: Haver, Morgan Stanley Research Estimates 1.0 Exhibit 6 US GDP Forecasts: 2012 and Liberal Conservative Source: James Thomson. A House Divided: Polarization and Its Effect on RAND. The RAND Corporation It goes without saying that this is not a trivial matter for the economic outlook because of the fiscal potholes looming in Assuming, as we do, that the payroll tax cuts and unemployment benefits are extended through year-end, the real fiscal drag kicks in starting January 1, The reason is that under current law, the Bush-era tax cuts expire, in addition to these temporary stimulus measures. Moreover, under the debt ceiling agreement from last summer, a total of Consensus GDP Forecasts 2.7 MS GDP Forecasts E Source: Bloomberg, Morgan Stanley Research Estimates E 1.7 5

6 The fiscal, and thus economic, prognosis for 2013 obviously depends on the election results, and that makes it the biggest policy risk in the US over the next year. How the election will turn out is still highly uncertain, and with it the exact fiscal policy actions in However, Exhibit 7 below presents potential policies under four different scenarios for the election outcome, depending on whether the White House and Congress are under Democratic or Republican control. The conjectures are certainly not definitive, but at least serve to suggest the direction that policy could take. While the Exhibit does not estimate the potential fiscal drag under each scenario, the divided government scenarios are more likely to result in only modest cuts and tax increases. That may be relatively positive for the economy in 2013, but wouldn t make much dent in the longer-term fiscal problems. Even before any of these policies would be implemented, the uncertainty over what they may be is likely to dominate the political discourse in 2012, and impact markets much sooner than the actual policy. For example, if it were to appear likely that the Republicans would win both the Presidency and a majority in both houses of Congress, the markets might start to anticipate more significant fiscal tightening, a likely negative for growth. At a minimum, the uncertainty over what the policies may be and the evolving uncertainty over what scenarios will play out will keep volatility high and investors once again a slave to policy and politics. Exhibit 7 Potential Policy Effects Under Different Election Outcomes Divided Government Divided Government Republican Sweep Democratic Sweep Democratic President Republican President Spending Significant cuts Selected increases Some cuts Some cuts Increases, particularly for missile defense Significant cuts in weapons and personnel Small cuts Almost no cuts Defense Non-Defense Significant cuts Selected increases Small cuts Some cuts Balanced Budget Amdt. to the States Yes No Unlikely Probably Taxes -- Extend Bush tax cuts for all Extend Bush tax cuts for under Extend Bush tax cuts for Extend Bush tax cuts for all Individual incomes, 0% on Gains, Dividends incomes $250,000 incomes under $250,000 incomes Taxes -- Repeal carried int., oil& gas Corporate Top rate to 25% incentives No change Modest reform Efforts to repeal PPACA and to Health privatize Medicare Efforts to expand health benefits Some Medicare cuts Significant Medicare cuts Maybe, if Senate filibuster Tort reform Significant reform None None overcome Tighter controls higher taxes cap Some increased exploration Energy Significant exploration increase & trade Little change and eased regulation Efforts to toughen EPA Environment Efforts to repeal EPA regulations regulations Little change Eased EPA regulations Trade Increase FTAs New labor and environ. stds. Little change Little change Efforts to toughen laws and Efforts to create pathways to Immigration enforcement citizenship Impasse Impasse Partially implement Dodd- Banking Significant revamp of Dodd-Frank Fully implement Dodd-Frank Implement most of Dodd-Frank Frank GSEs Efforts to disband, privatize mortgage finance Restore Slowly wind down Wind down Note: Republican Sweep = Republican president and a majority in both houses of Congress; Democratic Sweep = Democratic president and a majority in both houses of Congress; Divided Government is defined as one party winning the presidency and the other a majority of seats in both houses of Congress. Source: Davis Capital Investment Ideas 6

7 Global Cross-Asset Chart Corner US Equities Adam Parker US Rates Jim Caron Our year-end 2012 price target for the S&P500 is 1167, a price implying 7% downside from today s price by year-end. We think the risk-reward is skewed to the negative. Our bear case for the S&P500 is 944, and our bull case If 2011 was about the multiple contracting, we expect 2012 to be about earnings misses and downward revisions. We forecast year-end 2012 S&P EPS to be $100, and are 15% below consensus on 2013 earnings Consensus S&P 500 Earnings Estimates MS S&P 500 Earnings Estimates E 2012E 2013E Source: Thomson Reuters, Morgan Stanley Research forecasts US Equity Strategy: The 2012 Playbook, January We forecast breakevens to diverge further from real rates next year. Real rates fell precipitously in 2011 and the Fed is expected to conduct policy to increase the divergence between real rates and breakevens in Fed action through potential QE3 should raise inflation expectations and cause the gap between breakevens and real rates to increase Dec-09 Jun-10 Real Rates (left) Dec-10 Breakeven (right) Jun Dec-11 Source: Bloomberg, Morgan Stanley Research forecasts 2012 Global Interest Rate Outlook: Ambiguity - A Reshaping of Market Risk in 2012, November 29 Global FX Hans Redeker US Economics Vincent Reinhart We expect the USD to stay strong over the course of Deleveraging will cause global liquidity to retreat and volatility to trade at higher levels, suggesting safe haven currencies such as the dollar will stay strong. This coupled with slowing globalization will favor the USD; however, risks such as QE3 linger on the horizon. 1Q12 2Q12 3Q12 4Q12 EURUSD UDJPY GBPUSD USDCHF USDCAD AUDUSD NZDUSD EURJPY EURGBP EURCHF EURSEK EURNOK Source: Morgan Stanley Research forecasts FX Outlook: The Year of the Dollar, November 28 We expect US growth to be 2.2% in 2012 and 1.7% in 2013, and think inflation will somewhat subside. A key consideration in our forecast is that both households and the government are under pressure to delever, while a lack of wealth creation provides little support for increased consumption. We anticipate QE3 in the spring of 2012, and expect the economy to muddle through in the near term US GDP Growth (YoY %) E Base Bear Bull 2012E E Source: Morgan Stanley Research forecasts US Economics: Fed Thoughts for 2012: Into the Heart of Darkness, December 27 7

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