Investment Perspectives From The Global Investment Committee
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
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 re-caps, 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
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
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
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
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/.
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
Trend Line Earnings Growth Similar in Europe and US Earnings Per Share As of May 1, 2014 Why the recent gap? Source: BCA Research
Credit Growth the Key Difference Between US and Europe Corporate & Household Credit Growth¹ As of 2Q 2014 12% 9% 6% 5.1% 3% 0% -3% Positive Growth Negative Growth -1.8% -6% 1999 2001 2003 2005 2007 2009 2011 2013 United States Europe Source: Haver Analytics. (1) Corporate credit growth excludes Financials. Data includes mortgages.
Japan Still Not Getting Much Respect Topix Operating EPS Vs. Topix Index Level As of October 17, 2014 90 1,800 Topix Operating Earnings Per Share 70 50 30 10-10 -30 1,600 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
Big Drawdowns Are Infrequent Typically Coincide With Recessions S&P 500 Bear Market Downturns¹ and Recoveries Performance as of October 31, 2014 (Dark Grey Bars Indicate Periods of Recession) Downturn from Peak S&P 500 Peak to Trough Decline (%) Duration (Months) Subsequent Return (%) Price/Earnings Ratio Price/Book Ratio 3 Months 6 Months 12 Months Peak Trough Peak Trough Recover to Peak S&P 500 Date of Recovery Sep 1929 - Jun 1932-86.2 33 93 53 121 20.7 8.5 4.0 0.4 Jun 1932 - Sep 1954 267 Jul 1933 - Mar 1935-33.9 20 27 46 77 25.7 13.4 1.1 1.0 Mar 1935 - Oct 1935 7 Mar 1937 - Apr 1942-60.0 62 15 25 54 16.8 7.7 2.1 0.9 Aug 1942 - Jan 1946 45 May 1946 - Jun 1949-29.6 37 16 23 42 21.3 5.9 1.7 1.0 Jun 1949 - Jun 1950 12 Dec 1961 - Jun 1962-28.0 6 7 20 33 22.7 17.4 2.1 1.7 Jul 1962 - Sep 1963 14 Nov 1968 - May 1970-36.1 18 17 23 44 18.2 14.6 2.2 1.6 May 1970 - Mar 1972 21 Duration (Months) Great Depression Cuban Missile Crisis Jan 1973 - Oct 1974-48.2 21 14 31 38 18.2 6.9 2.0 1.0 Oct 1974 - Jul 1980 69 Nov 1980 - Aug 1982-27.1 21 36 44 58 8.7 7.7 1.3 1.0 Aug 1982 - Nov 1982 3 Aug 1987 - Dec 1987-33.5 5 21 21 26 20.2 13.1 2.2 1.6 Dec 1987 - Jul 1989 20 Mar 2000 - Oct 2002-47.4 31 20 13 36 25.7 17.6 5.0 2.5 Oct 2002 - May 2007 56 1987 Crash Oct 2007 - Mar 2009-55.3 17 40 55 72 17.5 10.2 3.0 1.5 Mar 2009 - Apr 2011 25 Average: -44.1 24.6 27.8 32.1 54.6 19.6 11.2 2.4 1.3 49.0 Source: FactSet, Bloomberg, Morgan Stanley Wealth Management GIC. (1) Downturns defined as declines of 25% or greater
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
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.