GLOBAL INVESTMENT COMMITTEE MAY 19, 2015 Positioning MICHAEL WILSON Chief Investment Officer Morgan Stanley Wealth Management M.Wilson@morganstanley.com +1 212 296-1953 The Solace of Being Alone Investing can be a cruel endeavor. On one hand, most successful investors spend countless hours engaging with data, research and people discussing the merits of these data and one s investment conclusions. In this regard, investing is very much a collaborative game that requires one to be social and willing to share. On the other hand, successful investing involves uncovering facts and trends that have yet to be discovered and then willing to take a stand that is out of favor or not yet obvious. In this regard, investing is taking solace in being alone isolation from the mainstream, which can be uncomfortable for most people. Yet, it is perhaps the most critical variable to making the really big calls correctly. For the better part of the past 18 months, the Global Investment Committee (GIC) has been making the case that the end of the Federal Reserve s Quantitative Easing (QE) program was the beginning of a monetary tightening cycle. While many say they agree with the premise that year-long tapering of QE is tightening, these same people then discuss what we should expect from markets when the Fed begins to tighten policy with its first interest rate hike, which is likely later this year. Huh? Next, they present an analysis of what has happened in the past when the Fed first raised rates to illustrate what should happen. The problem with this approach is that it will likely prove to be the wrong playbook for what is going to happen this year. Instead, the scenario being widely propagated is what they should have followed last year when the Fed ended QE. While this may not be such an out-of-consensus call, it is starting to feel more like it is based on the increasing number of reports I see from market pundits comparing the Fed s first rate hike to prior initial monetary tightenings. When the Fed first tightens in a monetary cycle, there are certain things that tend to happen in the markets: The yield curve flattens as long-term interest rates decline and short-term interest rates rise; the US dollar strengthens; smaller-capitalization and emerging market stocks underperform while growth and defensive stocks do well; and finally, broad stock market valuations Please refer to important information, disclosures and qualifications at the end of this material.
Exhibit 1: Financial Conditions Have Eased to Lowest Level in a Year 5 QE1 4 Morgan Stanley Financial Conditions Index 3 2 1 0 QE1.5 Tighter QE2 Twist LTRO Draghi QE3 BOJ QQE ECB BOJ QE QQE+ -1-2 Looser LTRO II Fed Ends QE -3 2007 2008 2009 2010 2011 2012 2013 2014 2015 Note: QE = Quantitative Easing; Twist = Fed sells short-term securities to buy long-term; LTRO = Long-Term Refinancing Operation, a European Central Bank (ECB) program to extend financing to Euro Zone banks; Draghi = Speech by ECB President Mario Draghi pledging to do whatever it takes to save the euro; BOJ QQE = Bank of Japan Quantitative and Qualitative Easing. Source: Bloomberg, Morgan Stanley Wealth Management GIC as of May 14, 2015 contract. Indeed, all of these things happened last year. Now that we are more than a year into the Fed s tightening cycle, we should be expecting the opposite: The yield curve steepens as longer-term interest rates rise faster than short-term rates; smaller-capitalization and emerging market stocks should do better; defensive and growth stocks underperform value stocks; and overall stock valuations should once again expand. This is exactly what appears to be happening as we approach the Fed s first hike, yet few pundits seem to see these trends. Instead, many are warning of an increase in volatility and the potential for a repeat of the Taper Tantrum we saw in 2013 when bond volatility spilled over into other markets, including equities. The good news is that the GIC has been positioned for this year s market moves thanks to our long-standing tapering is tightening thesis. In fact, our conviction in this idea led us to recently increase our existing positions before global interest rates moved sharply higher. This helped our asset allocation models avoid some of the price damage to long-duration bonds and real estate investment trusts while benefitting from the skew toward value stocks and inflation-protected securities (TIPS and WIPS). Nevertheless, I can t help but wonder if I should feel solace or despair in maintaining an out-of-consensus view. The bottom line is that financial conditions are actually easing at the moment. In fact, they are easing at an accelerating rate. This is happening because other central banks are more than offsetting the tightening by the Fed. Furthermore, with China recently joining the central bank party, these conditions are likely to keep easing even as the Fed finally raises interest rates, especially if they move slowly as we expect. This is the story that many investors are missing. Why take my word for it? Consider the Morgan Stanley Financial Conditions Index, an objective measure of monetary conditions in the US, which clearly shows that monetary conditions have eased significantly since the beginning of the year and are actually back to levels not witnessed since early 2014, when the Fed began tapering QE (see Exhibit 1). It also clearly shows how financial conditions have tightened throughout the past year, thereby supporting the thesis that tapering was, in fact, tightening. Going forward, I suggest watching this index for signs monetary policy is getting too tight rather than following playbooks that are a year late. The Right Playbook So if the Fed has already been tightening for more than a year, what is the right playbook? In other words, what typically happens in the 12-to-24 month period after the Fed has begun a tightening cycle? As already mentioned, we think interest rates will rise for most of this year. We do not believe the increase will be as abrupt as in 2013, but rates are likely to rise gradually in more of a sawtoothed fashion, a pattern that seems to be Please refer to important information, disclosures and qualifications at the end of this material. May 19, 2015 2
playing out already and which we expect to continue. This trend suggests interest rate-sensitive assets are likely to underperform this year, including long-duration bonds, real estate investment trusts, and bond-like equities such as utility stocks. It also explains why the US equity market has lagged global markets so far this year. The US equity market is the most defensive stock market in the world because it is also the highest quality. Conversely, foreign equity markets are the place to be this year because they are riskier and companies in those regions generally have higher operating leverage that allows them to benefit from accelerating economic and top-line growth. Therefore, as global growth improves via better monetary policy, lower oil prices and less fiscal austerity, these markets should perform well. Similarly, value stocks should have a catch-up move relative to growth stocks as investors discover they no longer need to pay a scarcity premium for growth stocks. Two sectors in particular stand out as value plays energy and financials. First, energy stocks are rebounding as the price of oil recovers. This is happening as supply and demand is quickly adjusting to these lower prices. To recall, oil prices declined sharply last year as global supply and demand got out of balance by about 1.5 million barrels per day. So far this year, demand is on track to regain close to 400,000 barrels per day. Meanwhile, the number of US drilling rigs has fallen by about half, and that should significantly reduce supply later this year. By our estimates, global supply and demand should be pretty close to balanced again by the end of the year. Of course, as oil prices recover the rig count will likely increase again. What s more, US shale oil projects can be restarted more quickly than traditional oil production. This argues for a lower range of oil prices once they recover. We think that the range will be $60 to $80 per barrel for Brent crude next year and probably slightly lower for US oil, or West Texas Intermediate. Nevertheless, this should bode well for energy stocks and certain energy-related master limited partnerships and we continue to recommend investors own them. The financial sector is also worthy of consideration. This sector has not done well since the financial crisis for several reasons. Some of this has to do with the deleveraging cycle and resulting weak credit demand. Furthermore, the crisis prompted regulatory changes that have hampered profitability and growth for many financial industries. Finally, the extreme low level of interest rates has been a drag on profits for financial firms. An Exhibit 2: Financials Have Historically Performed Well Following Rate Hikes 35 30 25 20 15 10 5 0 29.6 Four-Period Average Absolute Percent Total Return 12-to-24 Months After Initial Fed Rate Hike (left axis) Positive Relative Percent Total Return Hit Rates vs. Top 500 (right axis) 26.8 24.0 23.8 22.7 Note: Encompasses 1983, 1986, 1994 and 2004 rate hikes, the first in a new interest rate cycle. Top 500 stocks are 500 largest US stocks by market capitalization. Source: Morgan Stanley & Co., Morgan Stanley Wealth Management GIC upward move in rates and a steepening yield curve usually bode well for financial stocks. To get back to our thesis and the right playbook, we looked at how sectors perform in the 12 to 24 months following the Fed s initial tightening. Lo and behold, financials were the best performing and had a 100% hit rate to boot, which means they outperformed the Top 500 stocks in each cycle (see Exhibit 2). Putting all of this together suggests the financial sector is a strong candidate for outperformance this year. So far, however, financials have only performed in line with the broader market, but that performance has been much stronger recently. Of note, we increased our exposure to large-cap value stocks in April. This upward move in the sector has coincided with robust returns from financials globally. To me, this is an encouraging signal that financial stocks may be responding to all of the factors mentioned above and beginning a longer period of outperformance. In essence, they support our 2015 playbook. The China Syndrome 21.9 21.6 20.2 20.1 In 1979, Hollywood dramatized the risks of a nuclear power plant meltdown and the potential extreme consequences in The China Syndrome. Perhaps the most remarkable thing about this movie was that it was released just weeks before the actual nuclear power plant accident at Three Mile Island in Pennsylvania, only 100 miles from Philadelphia and 80 miles from Baltimore. Suffice to say, the accident didn t exactly hurt 18.3 14.6 100 90 80 70 60 50 40 30 20 10 0 Please refer to important information, disclosures and qualifications at the end of this material. May 19, 2015 3
the film s box office receipts. The China syndrome in the title refers to the fantastical imagery of a nuclear core meltdown in the US burning through the earth all the way to China. During the past few years, one of the most significant risks on investors minds has been that China s well-documented real estate expansion would lead to an inevitable bust. It has been suggested by many that such a bust would lead to a massive banking crisis in China which, in turn, would spill over to global financial markets; this China syndrome would be a meltdown in China s financial system that finds its way to the other side of the world. Based on the events of the past decade, it s easy to sympathize with the above view. After all, the 60 Minutes segments on China s ghost cities are downright horrifying. Of course, at this point the ghost cities are well known and discounted by markets. But the fallout remains a lingering risk because of the debt associated with these assets. The GIC has been positive on Chinese equities since March 2014, but if there is one area that has surprised us this year to the upside, it s China. Specifically, the big surprise is how aggressively the authorities in China have responded this year with pro-growth policies. The negative interpretation of these actions is that things have become so bad that the government is pulling out all the stops. While it s true the Chinese economy probably decelerated more than expected during the past 12 months, it is still far from recession and should benefit from the acceleration in both Europe and Japan, not to mention India and other countries in Southeast Asia. Secondarily, the 50% decline in oil prices is a huge boon to China, which imports virtually all of its consumption. These positive drivers haven t been lost on the local Chinese equity market, which is up 35% for the year to date and 100% in the past 12 months (see Exhibit 3). So what exactly is going on in China that has investors so excited? And, is this just another example of Chinese stimulus on steroids that ends up in overvalued assets or even more ghost cities? While charts like those in Exhibit 3 always contain speculative juices, sometimes they contain useful information, too information about real, unexpected change. In this case, I think we have a little of both. Let s start with the unexpected changes. First, as already noted the People s Bank of China (PBOC) has cut interest rates and lowered margin requirements for the banks. These actions have been more aggressive than expected and should release incremental capital into an economy that is growing its money supply too slowly to support its targeted 7% growth rate. Exhibit 3: China s A-Shares Running Far Ahead of H-Shares 220 200 180 160 140 120 100 Shanghai Stock Exchange A-Shares Index Hang Seng China Enterprises Index 80 May 14, 2013=100 60 May '13 Sep '13 Jan '14 May '14 Sep '14 Jan '15 May '15 Source: Bloomberg as of May 15, 2015 Secondly, the government announced a New Silk Road project last year to connect China to the Middle East and Europe via rail and a new Maritime Silk Road that will build and connect ports all the way to Africa. Third, China has championed the Asia Infrastructure Investment Bank as a means to help finance projects in regions that need access to capital. China will also help fund it with some of its tremendous $4 trillion in foreign exchange reserves. So far, more than 50 countries have joined this bank in an extraordinary show of support and higher than originally expected. Fourth, China is opening up its local stock market to foreigners and making it easier to execute cross-border transactions. In time, this will eliminate the need for special classes of stocks and lead to more free-flowing capital. This should help close the widening discount between local A shares and the H shares, which are for foreign investors. Finally, China has applied for special drawing rights with the IMF and there is a good chance it will get them later this year. If so, this will be a big step in moving China to developed-market status and perhaps the most important change for equity market money flows and prices. In short, there are many changes happening in China that could justify the move we have seen in its equity market in the past year. Keep in mind that Chinese stocks had gone nowhere for six years before they began their run last fall. No doubt it will be volatile, but we are sticking with our positive view with an emphasis on Chinese H shares, which should benefit from the current discount of more than 20% to locally owned A shares. We think this also supports our constructive view on oil and energy-related equities as China s economy responds to these changes, not to mention our 2015 playbook. Please refer to important information, disclosures and qualifications at the end of this material. May 19, 2015 4
Index Definitions MORGAN STANLEY FINANCIAL CONDITIONS INDEX This is a weighted index comprised of changes in equities, short-term interest rates, long-term interest rates and the US dollar. HANG SENG CHINA ENTERPRISES INDEX This a free-float-adjusted, capitalizationweighted index of the H shares, which are shares of mainland China companies that trade in Hong Kong. SHANGHAI STOCK EXCHANGE A-SHARES INDEX This index is a market-capitalizationbased index of all A shares trading on the Shanghai Stock Exchange. Risk Considerations MLPs Master Limited Partnerships (MLPs) are limited partnerships or limited liability companies that are taxed as partnerships and whose interests (limited partnership units or limited liability company units) are traded on securities exchanges like shares of common stock. Currently, most MLPs operate in the energy, natural resources or real estate sectors. Investments in MLP interests are subject to the risks generally applicable to companies in the energy and natural resources sectors, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk. 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. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments; this deferred tax liability is reflected in the daily NAV; and, as a result, the MLP fund s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked. Duration 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. 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. 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. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Please refer to important information, disclosures and qualifications at the end of this material. May 19, 2015 5
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. 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. Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. 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. Treasury Inflation Protection Securities (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation. REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change representative indices at any time. Disclosures The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein. The securities/instruments discussed in this material 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. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not Please refer to important information, disclosures and qualifications at the end of this material. May 19, 2015 6
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