JANUARY 2012 MARKET COMMENTARY GLOBAL INVESTMENT COMMITTEE Hypothetical Economic and Financial Scenario Analysis for 2012 David M. Darst, CFA Chief Investment Strategist IN BRIEF As we have done since 2000, this year we again draw extensively upon input from Morgan Stanley, Citi and Morgan Stanley Smith Barney investment thought leaders to prepare the attached, Hypothetical Economic and Financial Scenario Analysis for 2012. This one-page document describes six potential economic and financial scenarios for the 12 months ending Dec. 31, 2012, and provides resultant economic projections and capital markets conditions and assumptions associated with each scenario. Mindful of the difficulties associated with such an exercise, special attention has been paid to the disclosure and disclaimer sentences contained in the box and footnotes on the Hypothetical Economic and Financial Scenario Analysis page. We recommend that investors review each of these six scenarios, keeping this special language in mind: Each of these scenarios is composed of a number of hypothetical elements, not all of which may necessarily occur as described over the next 12 months. Other scenarios not described here may unfold, possibly including one or more of these postulated elements. It is also plausible that a projected scenario may come to pass without resulting in the associated economic or capital markets projections that are set forth in the column directly below it. Although these projections and outcomes are expressed as single-point estimates, investors would be wise generally to consider a range of values around many of these data points. It is important to keep in mind that asset allocation weightings may produce unfavorable results if a scenario other than the investor s specific expected scenario occurs. Given the likelihood of altered economic, financial, and geopolitical circumstances, and changing scenario probabilities over a twelve-month time frame, investors may wish to consider contingency plans, hedging strategies, and/or tactical portfolio modifications in anticipation of such changes. We also want to remind users of the 2012 Scenario Analysis that: (i) It is difficult to describe and/or assign a scenario probability percentage to the External or Internal Shock circumstance (Scenario 6) and depending on the nature and duration of such an outcome, an appropriate asset allocation may exhibit considerable variation from the one(s) shown here; and (ii) The specific Quality and/or Style apportionment within each of the five asset categories will vary according to the fundamental, valuation, and sentiment factors expected to affect specific asset classes. MORGAN STANLEY SMITH BARNEY LLC Please refer to important information, disclosures and qualifications at the end of this material.
MARKET COMMENTARY GLOBAL INVESTMENT COMMITTEE Hypothetical Economic and Financial Scenario Analysis for 2012 David M. Darst, CFA Chief Investment Strategist Please refer to important information, disclosures, and qualifications at the end of this material.
Hypothetical Economic and Financial Scenario Analysis for 2012 All Information As of Each of these scenarios is composed of a number of hypothetical elements, not all of which may necessarily occur as described during the next 12 months. Other scenarios not described here may unfold, possibly including one or more of these postulated elements. It is also plausible that a projected scenario may come to pass without resulting in the associated economic or capital markets projections that are set forth in the column directly below it. Although these projections and outcomes are expressed as single-point estimates, investors would be wise generally to consider a range of values around many of these data points. It is important to keep in mind that asset allocation weightings may produce unfavorable results if a scenario other than the investor s specific expected scenario unfolds. Given the likelihood of altered economic, financial, and geopolitical circumstances, and changing scenario probabilities, investors may wish to consider contingency plans, hedging strategies, and/or tactical portfolio modifications in anticipation of such peripeteia. Economic, Financial, and Geopolitical Scenario Elements (1) Economic Growth S&P Profits CPI Inflation US Treasury Interest Rates Currency Markets Geopolitics Economic Projections US Real GDP US CPI Inflation Rate S&P 500 Earnings Growth World Real GDP Potential Capital Markets Outcomes Year-ahead UST 10-Yr Int. Rates (2) Year-ahead UST 30-Yr Int. Rates (2) US Equities Tot. Return (S&P 500) (3) UST 10-Yr Tot. Return (2) UST 30-Yr Tot. Return (2) Projected Scenario Probabilities 1 Robust Economic Expansion US and global economic growth picks up smartly Profits increase decidedly Inflationary pressures intensify Interest rates rise more than expected The US dollar strengthens due to rising interest rates Geopolitical concerns are not a hindrance to growth + 3.5% + 4.0% + 20.0% + 5.2% 4.50% 5.50% + 22.00% 17.02% 36.07% 30% 32% 3% 2 Better-Than-Expected Economic Growth US and global growth modestly accelerate Profit growth exceeds consensus forecasts Inflation expectations begin to rise Interest rates increase The US dollar strengthens modestly Quiescent geopolitics aid economic growth + 3.0% + 3.0% + 12.0% + 4.5% 3.25% 4.25% + 16.00% 8.32% 19.30% 25% 30% 5% 3 Subpar, Sluggish Growth US and global GDP grow at below-average rates Earnings percentage increase is very low single digits Headline inflation remains muted Interest rate movements are benign US dollar: strong vs. Euro; weak vs. Yen/EM US domestic political trends remain inconclusive + 1.0% + 1.9% + 2.7% + 3.8% 2.00% 3.05% 5.00% + 0.93% + 0. 50% 19% 14% 37% 23% 7% 4 Stagnation and/or Stagflation Below-trend growth persists for several quarters Profits experience a shortfall vs. 2011 Inflation low, but worries begin Short-term interest rates up, long-term more The US dollar is relatively stable Global tensions show few signs of easing + 0.8% + 2.8% 5.0% + 3.0% 2. 3. 10.00% + 0.17% 2.53% 35% 5 Significant Recession The economy retrenches, with housing weakness and higher unemployment Profits decline meaningfully Some deflation sets in Excess liquidity and policy keep rates low The US dollar weakens Protectionist trade policies may begin to emerge 1.0% 0.5% 20.0% + 2.5% 1.75% 2.75% 20.00% + 2.85% + 5.53% 40% 6 External or Internal Shock A highly unfavorable event or events negatively affects global confidence Profits decline in the short-term Deflation fears arise (and later, inflation fears) Interest rates fall and credit spreads widen Currency volatility picks up Unsettled geopolitical conditions may pertain Potential 12-Month Time Horizon, Moderate Tactical Asset Allocation Weightings for US Dollar-Oriented, Global Equity-Centric High Net Worth Taxable Investors Expecting a Given Scenario to Unfold US Equity (3) Non-US Equity (3) Global Bonds (4) Global Alternative/Absolute Return (5) Cash (6) More Bullish Base Case More Bearish 2.0% 1.0% 30.0% + 1.8% 1.50% 2.50% 25.00% + 4.79% + 10.25% Notes: 1. Projected outcomes, probabilities, and allocations shown here are hypothetical only, and reflect input from Morgan Stanley Smith Barney Global Investment Committee and other strategists, economists, analysts, and asset managers inside and outside Morgan Stanley and Citi. 2. At the beginning of a projected one-year holding period for 2012, the 10-year 2.000% coupon due 11/15/2021 US Treasury yield to maturity is assumed to be 1.880% and the 30-year 3.125% coupon due 11/15/2041 US Treasury yield to maturity is assumed to be 2.895%. 3. The S&P 500 Index total returns for 2012 presume a year-end 2011 index level of 1,258 and a 2.12% dividend yield. The specific sectoral emphases of US and Non-US Equity exposure should emphasize defensive industry exposures in more bearish scenarios and assertive industry exposures in more bullish scenarios. 4. The specific duration, sectors, maturity, currency, and taxability of fixed income holdings are generally determined by the investor s own profile, preferences, and currency and interest rate outlook. 5. Includes: Real Estate/REITs; Commodities and Precious Metals; Oil, Gas, and Timber interests; Private Equity and Venture Capital; Private Real Estate; Managed Futures Funds; Hedge Funds; Hedge Fund Funds of Funds; and Inflation-Indexed Securities. 6. Depending on the short-term foreign exchange outlook, non-us dollar exposure in the Cash asset class may be implemented through currency ETFs. Source: Morgan Stanley Smith Barney Global Investment Committee. 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 or other financial instrument, or to participate in any trading strategy. This is not a research report as defined under NYSE Rule 472 or NASD Rule 2711 and has not been prepared by the Morgan Stanley or Citi Research Departments; it has been prepared by the 1 Morgan Stanley Smith Barney Investment Strategy Group. Please see additional important disclosures on pages 2-4 of this report. The indexes 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. Past performance is no guarantee of future results. Estimates of future performance are based on assumptions that may not be realized. Please refer to important information, disclosures, and qualifications at the end of this material. 5% 45%
Important Disclosures Index definition: The S&P 500 Index has been widely regarded as the best single gauge of the large cap U.S. equities market since the index was first published in 1957. The index has over US$ 3.5 trillion benchmarked, with index assets comprising approximately US$ 915 billion of this total. The index includes 500 leading companies in leading industries of the U.S. economy, capturing 75% coverage of U.S. equities. 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 or other financial instrument or to participate in any trading strategy. This is not a research report and was not prepared by the Research Departments of Morgan Stanley & Co. LLC or Citigroup Global Markets Inc. 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Morgan Stanley Smith Barney and its affiliates do not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used or relied upon by any recipient, for any purpose, including the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Each client should consult his/her personal tax and/or legal advisor to learn about any potential tax or other implications that may result from acting on a particular recommendation. 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. 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. 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Important Disclosures Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. 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. 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. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. 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. 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. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. An investment in an exchange-traded fund involves risks similar to those of investing in a broadly based portfolio of equity securities traded on an exchange in the relevant securities market, such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock and bond prices. Investing in an international ETF also involves certain risks and considerations not typically associated with investing in an ETF that invests in the securities of U.S. issues, such as political, currency, economic and market risks. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economics. For specifics and a greater explanation of possible risks with ETFs along with the ETF s investment objectives, charges and expenses, please consult a copy of the ETF s prospectus. Investing in sectors may be more volatile than diversifying across many industries. The investment return and principal value of ETF investments will fluctuate, so an investor s ETF shares (Creation Units), if or when sold, may be worth more or less than the original cost. ETFs are redeemable only in Creation Unit size through an Authorized Participant and are not individually redeemable from an ETF. Please consider the investment objectives, risks, charges and expenses of the fund(s) carefully before investing. The prospectus contains this and other information about the fund(s). To obtain a prospectus, contact your financial advisor. Please read the prospectus carefully before investing. 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. 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. 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. Physical precious metals are non-regulated products. Precious metals are speculative investments, which may experience short-term and long term price volatility. The value of precious metals investments may fluctuate and may appreciate or decline, depending on market conditions. If sold in a declining market, the price you receive may be less than your original investment. Unlike bonds and stocks, precious metals do not make interest or dividend payments. Therefore, precious metals may not be suitable for investors who require current income. Precious metals are commodities that should be safely stored, which may impose additional costs on the investor. The Securities Investor Protection Corporation ( SIPC ) provides certain protection for customers cash and securities in the event of a brokerage firm s bankruptcy, other financial difficulties, or if customers assets are missing. SIPC insurance does not apply to precious metals or other commodities. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Alternative investments which may be referenced in this report, including private equity funds, real estate funds, hedge funds, managed futures funds, and funds of hedge funds, private equity, and managed futures funds, are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and risks associated with the operations, personnel and processes of the advisor. 3
Important Disclosures Important Disclosures Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom. Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, sale, exercise of rights or performance of obligations under any securities/instruments transaction. Hypothetical Performance General: Past performance does not guarantee future results. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Hypothetical performance results have inherent limitations. The past performance shown here is simulated performance based on benchmark indices, not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results achieved by a particular asset allocation. Actual performance results of accounts vary due to, for example, market factors (such as liquidity) and client-specific factors (such as investment vehicle selection, timing of contributions and withdrawals, restrictions and rebalancing schedules). Clients would not necessarily have obtained the performance results shown here if they had invested in accordance with any GIC asset allocation, idea or strategy for the periods indicated. Despite the limitations of hypothetical performance, these hypothetical performance results allow clients and Financial Advisors to obtain a sense of the risk / return trade-off of different asset allocation constructs. Indices used to calculate performance: The hypothetical performance results in this report are calculated using the returns of benchmark indices for the asset classes, and not the returns of securities, fund or other investment products. Indices are unmanaged. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, accrued income and capital gains. Past performance of indices does not guarantee future results. Investors cannot invest directly in an index. Performance of indices may be more or less volatile than any investment product. The risk of loss in value of a specific investment is not the same as the risk of loss in a broad market index. Therefore, the historical returns of an index will not be the same as the historical returns of a particular investment a client selects. Fees reduce the performance of actual accounts: None of the fees or other expenses (e.g. commissions, mark-ups, mark-downs, advisory fees) associated with actual trading or accounts are reflected in the GIC asset allocation strategy or ideas. Fees and/or expenses would apply to clients who invest in investments in an account based on these asset allocations, and would reduce clients returns. The impact of fees and/or expenses can be material. Investing in the market entails the risk of market volatility. The value of all types of securities may increase or decrease over varying time periods. This material is disseminated in Australia to retail clients within the meaning of the Australian Corporations Act by Morgan Stanley Smith Barney Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813); Morgan Stanley Private Wealth Management Ltd, which is authorized and regulated by the Financial Services Authority, approves for the purpose of section 21 of the Financial Services and Markets Act 2000, content for distribution in the United Kingdom; This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. Recently, the Global Wealth Management Group of Morgan Stanley & Co. Incorporated and the Smith Barney division of Citigroup Global Markets Inc. combined into Morgan Stanley Smith Barney LLC, a new investment advisor and broker/dealer registered with the Securities and Exchange Commission. The URL on an e-mail address is not indicative of the author s employer. Morgan Stanley Smith Barney material, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney. 2012 Morgan Stanley Smith Barney LLC. Member SIPC. 4