Morgan Stanley Institutional Fund

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1 Morgan Stanley Institutional Fund Emerging Markets Fixed Income Opportunities Portfolio FIXED INCOME GLOBAL FIXED INCOME TEAM COMMENTARY DECEMBER 31, 018 Performance Review In the quarter period ending December 31, 018, the Portfolio s I shares returned -1.14% (net of fees), while the benchmark returned 0.30%. Market Overview Emerging market (EM) fixed income assets started and ended the fourth quarter on weaker footing as the optimism for global growth waned, punctuated by a sell-off in equity markets. While the market is not pricing in a recession in the near future, the outlook for global growth has continued to darken due to the risks arising from trade disputes emanating from the U.S. and the tightening of global financial conditions driven in part by rate hikes by the U.S. Federal Reserve (Fed). The optimistic trade mood generated from fitful progress on North American trade and positive signals between the U.S. and China was drowned out by the arrest Huawei s CFO in Canada and threats by the U.S. president to close the U.S. s southern border over internal budget disputes. Huawei (not held in the portfolio) is a Chinese technology company that has prompted global concerns about the use of its technology in telecom networks due to the company s purported links to the Chinese military. The reduction of global liquidity (the raising of policy rates and reduction of Fed balance sheet assets) has caused the market to focus on countries with external vulnerabilities, specifically those with twin deficits (current account and fiscal). This has led to pressure on assets, especially currencies, from Turkey, Argentina and South Africa. While the changing monetary policy landscape prompted a change in investor sentiment, most of these countries were facing their own idiosyncratic issues which left them vulnerable to shifts in risk appetite. While we recognize that year-to-date performance has been poor and the risks to the downside have grown over the year, there has been limited contagion and no substantial uptick in the outlook for defaults as the sell-off has been more idiosyncratically driven than systemic in our opinion. In Europe, Turkish assets continued to mitigate the steep losses incurred during the second and third quarter. The Central Bank of Turkey held rates steady in its last meeting as it remained cautious and data-dependent, while industrial production fell -5.7% year-over-year versus market expectations of -4.3%, highlighting the depth of the slowdown in activity. The International Monetary Fund (IMF) approved a 14-month $3.9 billion stand-by agreement for Ukraine, disbursing a first tranche worth $1.4 billion. The news was not enough to substantially lift Ukrainian assets as they ended the quarter down as Russia seized three naval vessels from Ukraine, prompting the imposition of martial law in Ukraine. Gross domestic product (GDP) growth in South Africa expanded.% quarter-over-quarter seasonally adjusted annual rate for the third quarter of 018, after two consecutive negative prints. Manufacturing activity contributed to the rebound in economic growth, as did consumption demand. However, operational challenges at the state-owned power producer Eskom have worsened, causing unplanned outages. Worsening financial conditions for Eskom (1.1% of the portfolio) may crystallize contingent liabilities onto the government s balance sheet, which could put pressure on South Africa s remaining investment grade rating from Moody s. In Latin America, the market-favored candidate for Brazil s presidency, Jair Bolsonaro, won the presidential election in the second round of voting, supporting the outperformance of Brazilian assets in the quarter. From the market s perspective, Bolsonaro s first policy agenda priority should be addressing the debt trajectory, which needs to be addressed via fiscal and pension reforms. 1 1 Source: Morgan Stanley Investment Management Limited. Data as of December 31, 018. Source: Bloomberg L.P. This document constitutes a commentary and does not constitute investment advice nor a recommendation to invest. The value of investments may rise as well as fall. Independent advice should be sought before any decision to invest.

2 It is important to note that most of Brazil s sovereign debt is denominated in local currency, not in U.S. dollars, which makes it less susceptible to external pressure and dollar funding. The Congress s composition has changed as a result of the elections and favors governability, thus increasing the probability of needed reforms. Mexican assets underperformed in the period, after outperforming the market for most of the year. Investors grew more concerned about the weakening of institutional strength in the country after the new President AMLO (Andres Manuel Lopez Obrador) cancelled the $13 billion Mexico City airport project using a limited sample, non-binding poll as political cover. The project is needed to increase transportation efficiency as it was slated to replace existing infrastructure which has been operating above capacity. But it has been the subject of AMLO s ire on claims of corruption and dirty money involved in the project. Fitch Ratings revised its outlook on the country to negative as a result. In Argentina, the trade balance posted a $979 million surplus with a significant decline in imports and a double-digit increase in exports. Inflation decelerated in Argentina with November Consumer Price Index print at 3.% month-over-month from 5.4% in October, still above market expectations. Argentina s Central Bank removed the 60% floor on rates based on the decline of money growth targets, as well as lower inflation and lower market-determined rates. The Central Bank also announced moving the foreign exchange band to % in the first quarter of 019 and stated that it could increase the monetary base if it sees signs of a higher demand for money and the increase is in line with higher foreign exchange reserves. In Asia, India s central bank chief, Urjit Patel, resigned as the relationship between the central government and the bank continued to show signs of strain. China s GDP year-over-year rose 6.5%, which was less than expected (6.6%), but is in line with 3 the overall slowing trend expected as the country continues on its development path. China s central bank cut the reserve requirement ratio by 100 basis points on eligible banks in order to ease liquidity conditions to combat trade-related growth weakness. The government has also cut income taxes and enacted measures to stabilize stock markets and financing for private firms. The government worked to build the market s confidence in its willingness to address the economic situation. Providing a measure of relief, in its latest report, the U.S. Treasury did not declare China a currency manipulator, reducing the case for additional trade restrictions on the country. In Sri Lanka, President Sirisena reinstated ousted Prime Minister Wickremesinghe, ending a political crisis started last October and providing the fuel for a rally in the country s dollar debt. Fund Strategy and Performance During the quarter, domestic debt positions in Brazil, Turkey, Indonesia, Egypt and Hungary added the most to performance. Conversely, positioning in Mexico, Venezuela, Kazakhstan, Ukraine and Colombia detracted the most. During the period we added to sovereign positions in local currency and dollar-denominated debt. From a country perspective we added in Indonesia, Guatemala, Costa Rica, Brazil and Nigeria, while trimming in Kazakhstan, Mongolia and Bahrain. Outlook After a challenging year for EM fixed income, we hold a constructive outlook for 019, driven by attractive valuations, a potentially benign global backdrop of moderate growth/subdued inflation and a Fed that is likely approaching the end of its tightening cycle. We believe these factors and growing twin deficits in the U.S. limit the scope for material U.S. dollar appreciation, which would be beneficial to EM borrowers. Our historical analysis indicates that EM fixed income tends to outperform when EM economies are closing negative output gaps and converging toward potential growth, as they are currently doing. Further support for local currency strategies should come from already adequately tight monetary policy in key EM economies and steep yield curves providing investors with excess term premium. Furthermore, overall EM foreign currency cheapness should enhance local currency returns from carry/duration, particularly if our expectation of a declining dollar and hawkish EM central banks were to materialize. Among credit, the hard currency EMBIG index screens as cheap versus both its historical average and traditionally comparable asset classes such as U.S. high yield, while our sovereign spread model suggests that there could be attractive spread compression potential from a fundamental perspective. Similar attractive opportunities can be found in EM corporates, where absolute and relative spreads have sharply underperformed other credit markets such as U.S. and European high yield in 018, despite generally improving fundamentals that are reflected in a similarly (low) default profile. Despite our overall constructive tone for EM debt next year, we acknowledge several risks that could undermine our thesis. The main risk concerns a worsening of U.S.-China trade relations. Though the recent truce reached at the G-0 meeting on December 1 is a step in the right direction, a final settlement of the ongoing disputes seems elusive in our view, as U.S. grievances involve issues that are critical to China s development model and on which Chinese authorities may be reluctant to compromise. We note, though, that a tariffs/counter-tariffs regime may also generate shifts in trade flows and relocation of supply chains to other countries, which could benefit several economies in EM. Moreover, the absence of synchronized global growth or loose global 3 Source: Bloomberg L.P. Source: National Bureau of Statistics of China

3 monetary policy implies that opportunities in EM will demand a discriminating approach to country/asset selection, especially with trade tensions and geopolitical risks on the rise. EM-specific drivers that are worth monitoring include policy signals from incoming administrations in systemically important EM countries such as Mexico and Brazil. Regarding the former, Mexican President AMLO s recent decisions to scrap the Mexico City airport and to consult the population on certain initiatives via legally questionable referenda bode poorly for policy predictability going forward. On the other hand, statements from the incoming Brazilian President Bolsonaro are more constructive, as he unveils a market-friendly economic agenda prioritizing fiscal consolidation, and particularly a swift pension reform. Finally, elections will be held in several EM economies in 019 that, if resolved positively, could provide further impetus to reformist agendas. In particular, we highlight important electoral contests in Indonesia, Ukraine, India, South Africa and Argentina. FUND FACTS Launch date May 4, 01 Base currency U.S. dollars Index Blended Index Performance (%) As of December 31, 018 (Class I Share at NAV) MSIF Emerging Markets Fixed Income Opportunities Portfolio - I Shares MTD QTD YTD 1 YR 3 YR 5 YR 10 YR SINCE INCEPTION Blended Index Performance data quoted represents past performance, which is no guarantee of future results, and current performance may be lower or higher than the figures shown. For the most recent month end performance figures, please visit morganstanley.com/im. Investment returns and principal value will fluctuate and fund shares, when redeemed, may be worth more or less than their original cost. The gross expense ratio is.01% for Class I shares and the net expense ratio is 0.84%. Where the net expense ratio is lower than the gross expense ratio, certain fees have been waived and/or expenses reimbursed. These waivers and/or reimbursements will continue for at least one year from the date of the applicable fund's current prospectus (unless otherwise noted in the applicable prospectus) or until such time as the fund's Board of Directors acts to discontinue all or a portion of such waivers and/or reimbursements. Absent such waivers and/or reimbursements, returns would have been lower. Expenses are based on the fund's current prospectus. The minimum initial investment is $5,000,000. Returns are net of fees and assume the reinvestment of all dividends and income. They are compared to an unmanaged market index. Returns for less than one year are cumulative (not annualized). Performance for one year or more is based on average annual total returns. The returns are reported for Class I shares. Performance for other share classes will vary. The Blended Index is comprised of 1/3 JP Morgan Emerging Markets Bond Index Global (tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the EMBI+. As with the EMBI+, the EMBI Global includes US dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million), 1/3 JP Morgan GBI-EM Global Diversified Index (a comprehensive global local emerging markets index that consists of regularly traded, liquid fixed-rate, domestic currency government bonds and includes only the countries which give access to their capital market to foreign investors (excludes China, India). The index is market capitalization weighted, with a cap of 10% to any one country) and 1/3 JP Morgan CEMBI Broad Diversified Index (a global, liquid corporate emerging-markets benchmark that tracks U.S.-denominated corporate bonds issued by emerging-markets entities). The returns shown prior to September 8, 015 are that of the JP Morgan Emerging Markets Bond Index Global, the fund s benchmark prior to the merger. Returns since the merger are that of the Blended Index. These indices are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index.

4 RISK CONSIDERATIONS There is no assurance that a mutual fund will achieve its investment objective. Funds are subject to market risk, which is the possibility that the market values of securities owned by the fund will decline and that the value of fund shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this fund. Please be aware that this fund may be subject to certain additional risks. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest-rate environment, the portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High yield securities ("junk bonds") are lower rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on Collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third party guarantees are insufficient to make payments, the portfolio could sustain a loss. INDEX INFORMATION The JP Morgan Emerging Markets Bond Index Global (EMBI Global) tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the EMBI+. As with the EMBI+, the EMBI Global includes US dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million. The JP Morgan CEMBI Broad Diversified Index is a global, liquid corporate emerging-markets benchmark that tracks U.S.- denominated corporate bonds issued by emerging-markets entities. The JP Morgan Emerging Markets Bond Index Global (EMBI Global) tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the EMBI+. As with the EMBI+, the EMBI Global includes US dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million. The JP Morgan GBI-EM Global Diversified Index is a comprehensive global local emerging markets index that consists of regularly traded, liquid fixed-rate, domestic currency government bonds and includes only the countries which give access to their capital market to foreign investors (excludes China, India). The index is market capitalization weighted, with a cap of 10% to any one country. IMPORTANT INFORMATION The views and opinions expressed are those of the investment team at the time of writing and are subject to change at any time due to market, economic, or other conditions, and may not necessarily come to pass. These comments are not representative of the opinions and views of the firm as a whole. Holdings and sectors/region weightings are subject to change daily. All information provided is for informational purposes only and should not be deemed as a recommendation to buy or sell securities in the sectors and regions referenced. This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision. Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness. Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus contains this and other information about the fund. To obtain a prospectus, contact your financial advisor or download one at morganstanley.com/im. Please read the prospectus carefully before investing. Morgan Stanley Investment Management is the asset management division of Morgan Stanley. NOT FDIC INSURED OFFER NO BANK GUARANTEE MAY

5 LOSE VALUE NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY NOT A DEPOSIT 019 Morgan Stanley. Morgan Stanley Distribution, Inc. CRC Exp: 1/31/019