Monthly Perspectives From the Global Investment Committee October 2014
Global Risk Aversion Reached Extreme Levels Morgan Stanley Standardized Global Risk Demand Index As of October 15, 2014 Complacent Extreme Fear Source: Bloomberg, Morgan Stanley & Co., Morgan Stanley Wealth Management GIC GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 2 of 19
US Equity Risk Premium Has Rarely Been Higher Spread: S&P 500 Forward Earnings Yield Vs. US 10-Year Treasury Yield As of October 17, 2014 Source: FactSet, Morgan Stanley Wealth Management GIC. Equity risk premium is the excess return that an individual stock or the overall stock market provides over a risk-free rate. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 3 of 19
With Global Equity Risk Premiums Even More Elevated Spread: Forward Earnings Yield Vs. 10-Year Government Bond Yield for Each Country As of October 17, 2014 Cheap Expensive Country 10/17/2014 (bps) China 738 Korea 735 Germany 713 Japan 673 Europe 632 France 606 Taiwan 589 Italy 519 US 474 Spain 470 Australia 377 Turkey 118 Mexico -77 India -219 Source: FactSet, Morgan Stanley Wealth Management GIC. Equity risk premium is the excess return that an individual stock or the overall stock market provides over a risk-free rate. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 4 of 19
Why Are Investors So Concerned? Fed transition to interest rate hikes next year timing and speed Europe s failure to deliver on monetary and fiscal policies Collapsing oil prices and what it means for shale and global growth Ebola Geopolitics Ukraine/Russia, ISIS in Iraq, Middle East generally Inflation expectations collapsing along with bond yields Can the world handle a stronger dollar? Positive catalysts: Tax cut from lower energy prices, European bank recaps, ECB asset purchases, solid earnings, share buybacks, lower interest rates, strong seasonal patterns Nov/Dec + mid-term elections; third year of presidential cycle Source: Morgan Stanley Wealth Management GIC GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 5 of 19
Our Thesis Tapering of QE Is Not the End of the Cycle Tapering is tightening despite the Fed s rhetoric it is not The initial tightening of monetary policy typically does not kill the economy or the stock market; instead, it signals self-sustainability However, market leadership changes as investors question the economy s ability to withstand the tighter policy We think 1994 and 2004 provide good examples of what to expect Many things support our thesis the yield curve is flattening, market leadership changing to late-cycle sectors, valuations have decreased, and M&A picking up all of which occurred in 1994 and 2004 GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 6 of 19
2014 Still Looks Like A Classic Mid-Cycle Correction Average Stock Performance S&P 500 1 As of October 15, 2014 Source: FactSet, Bloomberg, Morgan Stanley Wealth Management GIC. (1) Avg. percent change from 52-week high to market trough represents the average of the percent change of all SPX stocks 52-week highs leading up to the overall market correction that occurred in 1994, 2004 and 2014 vs. their closing price on the overall market trough date (shown in parenthesis next to each year). GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 7 of 19
Similarity to 1994 and 2004 Episodes Is Noteworthy Indexed Performance of S&P 500 from First Rate Hike/Initial Tapering of Quantitative Easing As of October 16, 2014 Source: Bloomberg, Morgan Stanley Wealth Management GIC GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 8 of 19
Earnings Are Still Very Supportive of Stocks S&P 500 Index Level Vs. S&P 500 Operating Earnings As of October 17, 2014 2,050 S&P 500 Index Level (left axis) S&P 500 Operating Earnings (right axis) 30 1,850 1,650 Stocks Overvalued 25 S&P 500 Index Level 1,450 1,250 1,050 850 Stocks Undervalued 20 15 10 S&P 500 Earnings 650 450 5 250 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Bloomberg GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 9 of 19
US Mid-Term Election Has Been Bullish for US Equities Dow Jones Industrial Average Around Mid-term Elections As of October 17, 2014 Source: Ned Davis Research. Copyright 2014 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 10 of 19
Shiller P/E Suggests Low But Not Negative Returns S&P 500 Cyclically Adjusted P/E Ratio (CAPE)¹ Vs. S&P 500 Total Returns As of September 30, 2014 0 23% 5 21% 19% Cyclically Adjusted P/E Ratio, inverted axis 10 15 20 25 30 35 40 CAPE Ratio for S&P 500, moved ahead 10 years, left axis S&P 500 10-year trailing annualized total (price+dividend) return, right axis 17% 15% 13% 11% 9% 7% 5% 3% 1% -1% -3% -5% S&P 500 10-year total return, annual 45 1937 1942 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 2017 2022-7% Source: FactSet, Morgan Stanley Wealth Management GIC (1) The cyclically adjusted P/E ratio (CAPE), also known as Shiller P/E ratio, uses a 10-year average of inflation-adjusted earnings to value the stock market. Historically, cyclically adjusted price-earnings ratios have led subsequent returns with a 10-year lag. GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 11 of 19
Moment of Truth: Will Earnings in Europe Accelerate? Eurostoxx Operating EPS Vs. Eurostoxx Index Level As of October 17, 2014 400 4,750 Eurostoxx Operating Earnings Per Share 350 300 250 200 150 100 50 0 4,250 3,750 3,250 2,750 2,250 Eurostoxx Price -50 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1,750 Eurostoxx Operating Earnings (left axis) Eurostoxx Price (right axis) Source: Bloomberg GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 12 of 19
Trend Line Earnings Growth Similar in Europe and US Earnings Per Share As of May 1, 2014 Why the recent gap? Source: BCA Research GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 13 of 19
Credit Growth the Key Difference Between US and Europe Corporate & Household Credit Growth¹ As of 2Q 2014 12% 9% 6% 5.1% 3% Positive Growth 0% Negative Growth -1.8% -3% -6% 1999 2001 2003 2005 2007 2009 2011 2013 United States Europe Source: Haver Analytics. (1) Corporate credit growth excludes Financials. Data includes mortgages. GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 14 of 19
Japan Still Not Getting Much Respect Topix Operating EPS Vs. Topix Index Level As of October 17, 2014 90 1,800 70 1,600 Topix Operating Earnings Per Share 50 30 10-10 -30 1,400 1,200 1,000 800 Topix Price -50 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 600 Topix Operating Earnings Per Share (left axis) Topix Price (Japan Stock Market, right axis) Source: Bloomberg GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 15 of 19
What Are We Concerned About? Is the ECB behind the curve and can they catch up before deflationary forces take root? Will the European bank stress tests be cathartic enough and lead to proper recapitalizations? Will Germany acquiesce? Is Japan experiencing bad inflation? Disenfranchised middle class around the world Can China transition to a consumer economy fast enough? Ebola is a wildcard Source: Morgan Stanley Wealth Management GIC GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 16 of 19
Bottom Line: Our Recommendations We continue to recommend equities over fixed income. Active managers should outperform passive at this stage given lower correlations. In the US, we prefer Healthcare, Tech and Consumer Discretionary. We believe US equities will advance in the fourth quarter on the back of strong seasonals. Japan is at the early stages of new bull market skepticism is high, valuations are low. Europe likely to remain choppy given concern about growth, the bank stress tests due in late October and Germany taking hard line on fiscal austerity add on weakness. Emerging markets are very idiosyncratic and have performed better than expected this year. We prefer India, Mexico, China and many parts of Southeast Asia. For fixed income, we still recommend below-benchmark duration. Don t get complacent. Recent pullback in high yield creates opportunity. Municipal bonds look fairly valued. We still like Master Limited Partnerships (MLPs) as an attractive way to invest in US Energy infrastructure. Growing yield from these securities appears compelling in a low interest rate world. Be very selective at this stage. Commercial real estate in the US appears more interesting at this point as it typically lags residential recovery. Similarly, international real estate appears more favorable than U.S. Source: Morgan Stanley Wealth Management GIC. For more information about the risks to Duration and Master Limited Partnerships (MLPs), please refer to the Risk Considerations section at the end of this material. GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 17 of 19
Asset Class Risk Considerations and Disclosures For index definitions to the indices referenced in this report please visit the following: Index Definitions Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Investing in foreign markets entails risks not typically associated with domestic markets, such as currency fluctuations and controls, restrictions on foreign investments, less governmental supervision and regulation, and the potential for political instability. These risks may be magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value. Bonds are subject to interest rate risk, call risk, reinvestment risk, liquidity risk, and credit risk of the issuer. High yield bonds (bonds rated below investment grade) may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk, price volatility, and limited liquidity in the secondary market. High yield bonds should comprise only a limited portion of a balanced portfolio. Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one's state of residence and, if applicable, local tax-exemption applies if securities are issued within one's city of residence. Master Limited Partnerships (MLPs) 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. 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. 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. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. 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. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Rebalancing does not protect against a loss in declining financial markets. There may be a potential tax implication with a rebalancing strategy. Investors should consult with their tax advisor before implementing such a strategy. 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. Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. 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. Past performance is not necessarily a guide to future performance. 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. GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 18 of 19
Disclosures (cont d) 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 and our third-party data providers make no representation or warranty with respect to the accuracy or completeness of this material. Past performance is no guarantee of future results. 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 acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material. Morgan Stanley Wealth Management 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. This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC. Morgan Stanley Wealth Management is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the Municipal Advisor Rule ) and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning the Municipal Advisor Rule. 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. Morgan Stanley Wealth Management research, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC. 2014 Morgan Stanley Smith Barney LLC. Member SIPC. GLOBAL INVESTMENT COMMITTEE GIC CHARTBOOK Page 19 of 19