GLOBAL INVESTMENT COMMITTEE / COMMENTARY APRIL 2015...

GLOBAL INVESTMENT COMMITTEE / COMMENTARY APRIL 2015

On the Markets

MICHAEL WILSON

Chief Investment Officer Morgan Stanley Wealth Management

TABLE OF CONTENTS

2 For Whom the Dollar Tolls Just how does the strong dollar impact the US stock market?

4 The New Titans of Tech They’re in “SMAC”—security, mobile/social, analytics and the cloud.

5 Bullish on Chinese Stocks “New China” is ascendant and should be good for equities.

6 Why the Euro Is Likely to Remain Down The economic data from Europe is getting better, but it is not helping the euro much.

7

What Would Make Us Bullish on the Emerging Markets Many things need to happen in specific countries and the region as a whole.

9 Oil’s Impact on Corporate Bonds Transportation does best, and the consumer sector fares well, too.

10 Muni Investors Get Paid to Wait Some sit waiting for rates to go up, others take advantage of high relative returns.

11 Q&A: Buying Bonds in a Brutal Market AB’s Doug Peebles says, even with ultralow rates, people need to own bonds.

13 Active and Passive Strategies Our new opportunistic approach to equity investing mixes both strategies.

Déjà Vu All Over Again

With the first quarter of the year behind us, though 2015 is shaping up to be similar to 2014 in many ways, it is also exhibiting unique traits of its own. From a similarity standpoint, the S&P 500 Index was down 3.1% in January, up 5.5% in February and then down 1.7% in March, leaving the index up just 0.5% for the first quarter of 2015. This mirrors 2014, for which the S&P 500 was down 3.6% in January, up 4.3% in February and up 0.7% in March, also leaving the index up approximately 1% for the first quarter last year.

As in 2014, this year’s market performance has hung on every word and action—or inaction—of the Federal Reserve and its chair, Janet Yellen. From a fundamental standpoint, this year has been similar to last year in that the US economy suffered from a harsh winter, leaving first-quarter real GDP growth below the already anemic 2% trend-line growth in place since the financial crisis.

However, this is where the similarities end. Last year, market volatility was driven by an emerging market currency crisis as investors worried about the end of the Fed’s Quantitative Easing and what effects it could have on many emerging market countries’ balance sheets. This year, it’s been more about the relentless decline in commodity prices and rise in the US dollar—both of which can have negative repercussions for US earnings. Last year, the drag on growth was centered on the economy, and earnings estimates were virtually unscathed. This year, the drag is on earnings. The forward 12-month consensus estimates for the S&P 500 came down more than 5% from late October through mid March—the biggest decline since the financial crisis and Great Recession.

The good news is that these estimates bottomed a few weeks ago and have now risen more than 1% from the trough. We expect that new upward trend will continue on the back of first-quarter results and renewed company guidance. History shows that big positive moves in the US dollar and declines in oil prices tend to have a disproportionately negative effect on S&P 500 earnings estimates initially, but that those effects are subsequently reversed. We believe the recent uptick in estimates could be the beginning of that reversal. The end result is that US equities are likely to rebound, too, and perform better than they did in the first quarter—perhaps this is, with a nod to the eminently quotable Yogi Berra, déjà vu all over again.

ON THE MARKETS / EQUITIES

Please refer to important information, disclosures and qualifications at the end of this material. April 2015 2

ADAM S. PARKER, PhD Chief US Equity Strategist Morgan Stanley & Co,

ince at virtually every recent investor meeting, participants’ questions have

surrounded the dollar, oil and interest rates, we thought it would be helpful to walk through our thoughts on these topics.

How does the dollar impact US stocks? Our work shows that, historically, the price/earnings ratio (P/E) for the market expands when the dollar strengthens. In the past, for every 6.0% the dollar increased against a trade-weighted basket of currencies, the market pulled back by an average of only 1.1%. There were some periods during which the market rallied while the dollar strengthened, as both the higher dollar and the market rally reflected a relatively stronger US economy—something that seems relevant today.

Still, as an acknowledgement of the sharply falling euro of late and the typical market behavior of lower earnings and higher multiples, we have lowered our 2015 S&P 500 earnings-per-share (EPS) estimate to $124 from $126 (see chart). In addition, we have also raised our P/E estimate to 17.4 from 16.9. Our year-end price target of 2,275 for the S&P 500 remains unchanged.

That $124 reflects 4% EPS year-over-year growth, which implies an upside to Wall Street’s current consensus estimate of less than $120. That estimate was $134 only a few months ago, and we figure that roughly half of the decline comes from lower oil prices and their direct contagion on energy, industrials, materials and chemicals. The other half of the decline is due to the stronger dollar.

As the year unfolds, we believe that analysts will ultimately need to raise their forecasts because there are clearly areas of the economy and companies that are not affected by a stronger dollar and benefit from lower oil and rates. In the first quarter, nearly five companies have given negative guidance for every one that issued positive guidance, which sets the bar quite low for the earnings-reporting season about to get under way. We wouldn’t be surprised to see upward revisions in consumer discretionary, financials, health care and even energy later in the year.

For sure, the strong dollar doesn’t have a uniformly negative impact on all businesses. Our work shows that consumer staples, machinery, chemicals, select technology and select health care companies are most at risk, and we are not overweight any of these areas. Banks generally perform well when the dollar strengthens.

US or non-US equities? Several times in the past few weeks investors have asked us about US equities relative to European equities. Our view is that the two markets

have a 0.7 correlation over the long term, and both will be positive. Macro and long-term investors have told us owning Europe over the US is “easy” because: The currency helps; margins are much lower in absolute terms; P/Es, while not cheap relative to their own history, are relatively lower; and Europe now has a far more aggressive monetary policy than the US.

Our view is probably more indifferent between the two markets. Why? The US is basically Europe if you take out all the awesome companies. Think about the businesses that exist in the US relative to Europe. Within the top-30 US companies by market capitalization are businesses or business models—world-class leaders in technology, health care and retail—that just don’t exist in the European markets. Moreover, the banks in this mega-cap group are in better financial shape, broadly, than their European counterparts. So our sense is that the US should trade at a substantial premium. When we look at stock performance year to date (through March 31), we see the EURO STOXX 50 Index up 17.7%, but only 4.5% in dollars. This is similar to how the Nikkei 225 traded a few years ago (though not this year), when much of the gains were explained by the yen.

Is this a bubble? There are stretched valuations, and variables that don’t appear to be equally discounted across all of our markets but, at least to us, there is

For Whom the Dollar Tolls

S

Morgan Stanley & Co. S&P 500 12-Month Price Target EPS

Landscape Scenario

Probability 2015E 2016E P/E Ratio

Scenario Target

Upside / Downside

Bull Case 20% 132.1 146.6 18.8 2,750 33.0%

Growth 11% 11%

Base Case 60% 124.0 131.0 17.4 2,275 10.0%

Growth 4% 6%

Bear Case 20% 111.9 111.9 15.2 1,700 -17.5%

Growth -6% 0%

Current S&P 500 Price 2,068 Source: Thomson Reuters, Morgan Stanley & Co. Research as of March 31, 2015


officially a bubble in government bonds. It may be January 2000, when the bubble is about to burst, or it is 1995 and this can go on for some time. All we know is you have to be straight crazy to buy a French 10-year Government bond, which yields 0.48% per year, or a 10-year German Bund for 0.1%, both of which are lower than the current S&P 500 dividend yield and those of their local markets (see chart).

While we discussed consensus bottom-up EPS estimates earlier, please remember that there will also be more than a 2% net buyback. So the S&P 500 offers more than a 4% total yield (dividend plus repurchase yield), with low payout ratios versus history, high cash balances and high interest coverage. It seems to us that equities will be better than government

bonds in all but a Great Depression. What do we do with the 10-year

bond? Most Wall Street firms haven’t exactly covered themselves in glory calling the long end of the curve in the past few years. That said, it does seem prudent to start moving the portfolio away from high-yielding stocks whose valuations are not compelling and toward stocks sensitive to moves in rates. A few weeks ago we began the process by reducing exposure to telecoms and adding to financials.

Financials are now our third-favorite sector out of 10. While we acknowledge rates are a key component of the call, we also get the sense that the bull/bear ratio is skewed to the positive for the sector. If the

10-year US Treasury yield goes back to 1.7% or lower, financials will likely underperform. Still, our guess is that they will underperform by less in that scenario than they will outperform if the Federal Reserve hikes rates in June or September or if the long end rises 25 to 50 basis points more this year. So, increasingly, we like the risk-reward of financials. The banks are not affected historically by a stronger dollar, and the results of the recent stress tests should be quite positive for the sector's year-over-year growth in shareholder return, both in absolute terms and relative to other sectors.

What’s at risk? We think there are two areas of the market that will be sold hard if the Fed hikes or if investors begin to believe the long end will continue to back up. First will be the offensively expensive defensives, like utilities and consumer staples, both of which we remain underweight, as well as real estate investment trusts and master limited partnerships. Perhaps this is the consensus view, but we think the risk-reward is skewed to the negative. We particularly would avoid consumer staples, given they have high exposure to a strong dollar.

Some growth stocks could be at risk, too. Why? Some hawkish commentary from Fed Chair Janet Yellen last year caused a huge rotation out of growth in March and April. Today, the hedge fund industry has its highest exposure to the growth universe since 2008. We worry that investors are crowded into select health care and technology and that this rotation could happen again. Our view is financials and energy could be the beneficiaries of this rotation.

Outside the US, Dividend Yields Are Higher Than Yields on 10-Year Government Bonds

*Dividend yields are based on MSCI country indexes. Source: FactSet, Bloomberg, Morgan Stanley Wealth Management GIC as of March 18, 2015

4.3%

3.6%

2.9% 2.9% 2.8%2.5%

1.9%1.7%

2.3%

1.6%

-0.1%

0.5%

1.4%

0.2%

1.9%

0.4%

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Australia UK Switz. France Canada Germany US Japan

%Dividend Yield* 10-Year Government Bond Yield



CASEY GALLIGAN Market Strategist Morgan Stanley Wealth Management VIJAY CHANDAR Market Strategist Morgan Stanley Wealth Management

s the Nasdaq Composite once again hovers around the symbolic 5,000

level, there has been plenty of talk about the ghosts of the 1999-2000 tech bubble. However, unlike 15 years ago, today’s tech-company valuations and free-cash-flow profiles are more reasonable—and the companies are profitable. All this leads us to believe the sector will continue to evolve and offer opportunities. Thus, rather than fear the approaching all-time highs on the Nasdaq, investors should diversify their tech exposure by owning leading companies in the key secular growth areas that we believe will produce outsized returns—specifically those with exposure to “SMAC”: security, mobile/social, analytics and the cloud.

Morgan Stanley Wealth Management’s Global Investment (GIC) believes that companies levered to these key secular growth areas will continue to be differentiators. Security, cloud computing and analytics are 2015’s top-three spending priorities for chief information officers (CIOs), according to Morgan Stanley & Co. survey of 100 US and 50 European CIOs (see chart). The GIC also expects mobile computing to be an important focus as time spent on devices increases and companies ramp up ad spend and mobile payment capabilities. Specific strengths of these key areas include:

•Security. For nearly two years now, industry surveys have shown that security is the top spending priority of corpora-tion’s CIOs. That’s not surprising given

the high-profile security breaches in the news of late. In addition, with security, CIOs rely on external expertise more than in any other technology category.

•Mobile/Social. Thematically, 2015 is about mobile and video. Ad spending on mobile devices is expected to continue to take market share from other platforms as time spent on these devices increases.

•Analytics. With companies collecting more data than ever before, data analytics software has become essential, and we see robust growth for data-analytics com-panies that provide economic, scalable and value-added solutions to customers.

• Cloud Computing. We believe customers will ultimately look to utilize fewer rather than many public clouds in order to better integrate workflows, analyze data and simplify operations.

LONG MEMORIES. Though largely based on legacy opinions rather than the current data, some investors remain wary about tech investing, says Adam Parker,

MS & Co.’s chief US equity strategist. As new business models have emerged and succeeded in the sector, tech companies no longer resemble the make-shift operations that quickly burned through their cash more than a decade ago. In 1999, fewer than half of the technology companies were profitable. Currently, while there are always going to be some headline examples to the contrary, approximately 90% of technology companies have positive operating margins and the tech sector has the highest free-cash-flow yield of any market sector. In addition, more than one-third of the $1.7 trillion in cash on the balance sheets of US companies today belongs to technology firms.

SIMILAR RISKS. To be sure, there are still risks to tech investing. Monetary tightening could trigger a sell-off that would be especially hard on high-growth tech companies, and concerns about global growth could reemerge and force customers to cut spending. What’s more, high growth expectations may already be priced into some of the SMAC stocks, which sets a high hurdle for companies and one that leaves little margin for error. Still, though the risks may sound familiar, the tech landscape is far different from the last time the Nasdaq was at these levels.

Consider the New Titans of Tech

A

Expected 2015 Spending Increases on Top IT Projects

*Data warehousing, business intelligence and analytics **Enterprise resource planning Source: MS & Co. as of Jan. 31,2015

11.5%

8.1%

6.5%

3.5%2.6% 2.3% 2.2%

1.2%

0

2

4

6

8

10

12

14 %Expected Net Increase in Spending on Top IT Projects



JONATHAN GARNER Chief Asia and Emerging Market Strategist Morgan Stanley & Co.

China has begun a new phase of its development.

With slower GDP growth and a rising share of consumption/services activity, China’s economy is starting to look like that of Japan 40 years ago and that of Korea 20 years ago. What’s more, our bottom-up analysis indicates progress is more advanced than official GDP statistics suggest. However, China still faces the challenges of deleveraging its state-owned-enterprise sector and implementing structural reform. It will be a multiyear process.

“New China” is ascendant.

New China, a designation for the health care, information-technology and consumer sectors, should continue to be the major engine of China’s economic growth in the next five to 10 years. Since 2008, New China’s earnings per share has grown at an 8.2% compound annual growth rate as compared with -2.3% for “Old China”—materials, energy and industrials. We believe that the combination of progress on structural transition/reform and weaker short-term economic growth will strategically allow New China to continue its outperformance versus Old China.

Chinese equities are cheap.

On an absolute basis and as compared with other emerging markets in Asia, Chinese equities are attractive. The MSCI China Index, with a 12-month forward price/earnings ratio of 10.1 on our earnings estimates, trades cheap relative to its history and to its peers. Chinese equities also have better historical and prospective US-dollar earnings-per-share growth than Asia’s other emerging markets. Chinese equities are in a bull market.

We think the “A shares” are repeating the 2005-to-2007 bull market due to support from policymakers, the monetary easing cycle and local investors reengaging in equities. For performance this year, we prefer A-Shares to the Hang Seng China Enterprises Index or the Hang Seng Index. For the year to date (through March 31), the Shanghai Stock Exchange A-Shares Index is up 16% in both local and in US-dollar terms. Though A-shares are generally available only to citizens of mainland China, foreign investors can gain exposure to them via mutual funds and exchange-traded funds.

Four Reasons to Be Bullish on Chinese Equities

The Rise in Chinese Stocks Is Starting to Resemble the Lead-Up to the 2005-to-2007 Bull Market

Source: Bloomberg as of March 31, 2015

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000 Shanghai Stock Exchange A-Shares Index

ON THE MARKETS / CURRENCIES


HANS REDEKER Head of Global FX Strategy Morgan Stanley & Co. International plc

or the past month or so, economic reports in Europe have improved

noticeably, led by better-than-expected employment gains, domestic demand and inflation in Germany. However, despite a brief tick up in late March, the euro has continued to decline toward cycle lows. What is prompting this disconnect between outperformance in growth and currency returns?

As we’ve been noting during the past year, we believe the euro will continue to decline despite a moderate growth pickup as it undergoes a structural transition. Specifically, we highlight two forces that have weighed, and are likely to continue to weigh, on the common currency.

HEDGING IMPACT. First are hedging flows. In this regard, the euro now trades

much as the yen did after the start of Abenomics. Though foreigners are certainly buying European equities in large size amid improving growth and potential reflation, these inflows are often done on a currency-hedged basis, so the euro gets only limited support (see chart). We believe that investors are increasing currency hedges on existing European equity holdings as well, given that a foreign investor essentially gets paid to remove currency risk from their European investments. This flow is likely to weigh on the euro for some time to come and is apt to dampen any rallies.

The second force keeping the euro on its downward trajectory is the increasing use of the common currency as a funder. Ahead of the European Central Bank’s Quantitative Easing program in an environment of negative net European

issuance, yields have compressed markedly. As such, the yield differential between the euro and the rest of the G3 has continued to widen, with euro interest rates now even falling below those in Japan.

RECORD ISSUANCE. In this environ-ment, investors, corporations and even sovereigns are switching away from traditional funding vehicles, such as the dollar and the yen, and instead turning to the euro. In fact, in late February the euro bond market saw the largest-ever issue by a US company. They are not alone in this regard; foreign companies are broadly borrowing in euros, taking advantage of the extraordinarily low rates and high demand for yield in Europe.

Finally, our European economics and strategy teams have highlighted that the largest domestic holders of European debt—banks and insurers—are unlikely to sell their fixed income securities to the European Central Bank (ECB) for its Quantitative Easing program. Rather, we believe that foreign investors are going to be the primary group of sellers. This weighs on the euro via a natural-flow effect as foreign investors are displaced from the European bond market while the ECB pushes down on yields across the curve. The absorption of such a high share of net European issuance should lead to further widening of interest rate differentials between Europe and other major bond markets.

Indeed, ECB President Mario Draghi’s willingness to buy bonds until reaching a negative deposit rate of -0.2% offers a powerful signal to the market that European yields will continue to trade heavily compared with G10 peers. Rate differentials, not just at the front end but across the curve, should continue to favor shorting the euro, which, in turn, puts further pressure on the currency.

.

Why the Euro’s Down and Probably Out for a While

F

Investors Flock to European Stocks, but Their Hedges Put Downward Pressure on the Euro

Source: Bloomberg as of Feb. 27, 2015

-2

0

2

4

6

8

10

12

14

16

18

Jan '14 Apr '14 Jul '14 Oct '14 Jan '15

Cumulative Flows to EuropeEquity Exchange-Traded FundsCurrency Hedged Currency Unhedged

Billion$

ON THE MARKETS / ECONOMICS


MANOJ PRADHAN Global Economist Morgan Stanley & Co. International plc

t is now nearly three years since we first argued that emerging market (EM)

growth models were broken. With hindsight, the EM economies started downward a year before that assertion. Without flexible markets and regulations that can respond to shocks, only reforms and/or macromanagement or a catharsis induced by external events can help to bring about sustainable growth.

In our view, only India, Mexico and Indonesia have passed the inflection point en route to a new model of growth. That is a measure not only of the severity of the structural drag on EM growth, but also of the reluctance of policymakers to implement an adjustment that generates significant near-term pain even if it is for longer-term gain. As a result, we have maintained that external events will have to trigger EM change. With an anemic recovery in the developed markets, uber-expansionary central banks and a steady slowdown in China, external shocks have simply not been strong or persistent enough.

MEASURING PROGRESS. Now, we can envisage a scenario in which a process of catharsis could restore healthy trend growth in the next 12 to 18 months. To measure progress, we have signposts along the way (see table, page 8).

The postcatharsis trend growth will likely be lower than the precrisis level—but the higher quality should generate a case for investment. We believe that the quality of this new, lower trend growth

will be superior, given that capital will be forced into productive activities. If this happens, incremental capital-output ratios would fall—i.e., there would be more growth per unit of capital, suggesting a bigger bang for the (borrowed) buck and hence a higher-quality rate of return on physical and financial assets. What explains the decline in trend growth? Simply, the difference between precrisis and postcrisis EM trend growth will be roughly proportional to the precrisis export-oriented investment that was enabled by US consumers.

THE GREAT UNWIND. The triple unwind of low real rates and a weak US dollar in the US, high leverage in China and the leveraged growth cycle in emerging markets form the basis for moving resources into more productive activities. The onset of all three of these dynamics had generated capital misallocation and hence falling EM returns and growth.

Some economies—India, Indonesia, Mexico, Taiwan and Poland—have already adjusted while those of Brazil, Russia, South Africa and Turkey have not. Those who are yet to go through adjustment will have different paths depending on the nature of their problems. Brazil, Russia, South Africa and Turkey, which face EM issues like inflation and external exposure, will likely have less protection against external shocks than the likes of China and Korea, which have developed market drags on growth such as deflation and debt.

CHINA CHANGES. As for China, we see its adjustment as 40% done. On the plus side, services share in GDP is rising fast

and China’s global export market share also continues to rise. However, deleveraging and reforming the mid- and large-cap state-owned enterprises and accelerating the transition to consumption- driven growth will be crucial. Rising global rates could raise the risk of (further) capital outflows and push domestic real rates higher. If slower investment spending ultimately weakens the more vibrant consumer economy in China, this could front-load the spillover to the rest of the emerging markets much like the collapse of commodity prices already has for commodity producers.

What would make us EM-equity bulls? We do not appear to be close to a turning point in EM stocks’ return on equity relative to that of the developed markets—a metric that has been falling for more than four years. Both margins and asset turnover are under pressure and neither absolute nor relative valuations are cheap enough. The most important macro factor that needs to reverse is a turn in the US dollar or the front-loading of the effects of a strong dollar. Commodity-price weakness is less of a headwind than in the past due to the rising weight of EM Asia within the MSCI Emerging Markets Index. With some exceptions, the countries that have shown more adjustment are trading on higher valuations than markets where adjustment is lagging.

BECOMING CREDIT BULLS? What would make us EM-credit bulls? Getting through the Fed hike and any potential large rise in US Treasury yields would remove near-term risks. For a bull market in credit, we need to see structural macro improvements and moderation of the rise in debt levels, both public and private. This could lead to a reversal of the recent EM rating downgrade cycle. Indeed, Asia credit is starting to benefit from corporations deleveraging their balance sheets. This healthy, micro-driven dynamic can be sustainable and provide meaningful upside to investment grade

What Would Make Us Bullish on the Emerging Markets?

I


credit if growth is stable. Weaker growth creates the most downside for high yield. Companies in Asia ex Japan are better protected from rising rates and a strong dollar thanks to low dollar debt and ample

foreign exchange assets. What is the risk to our scenario? No adjustment. This could happen either because the DM-like economies use their “protection” to avoid adjustment or if the

Fed’s rate-hike cycle is considerably slower and more circumspect than the consensus anticipates. If the Fed moves decisively, adjustment could move beyond the point of no return.

Signposts: What Do We Want to See to Become EM Bulls? EM Less export-oriented: Need to move investment toward the domestic economy and export markets where EM dominates (EM export growth is

negatively affected by DM economies that look more like competitors than consumers.)

EM For DM-like economies (China, Korea): More services than manufacturing, and less housing-related investment, greater recognition of nonperforming loans (NPLs), deal with excess capacity

EM For Dutch Disease-afflicted economies (Russia, Brazil, Malaysia, Indonesia): More competitive manufacturing, lower real effective exchange rate (REER) with real wage disinflation, shift in employment trends from consumption-oriented services to manufacturing

EM For low-savings economies (Brazil, Turkey, South Africa and, to a lesser extent, Indonesia and India): Fiscal responsibility to raise public savings and reasonably high real rates to protect domestic savings

EM For externally exposed economies (Brazil, Turkey, South Africa, Mexico, Indonesia): High enough real rates and slower growth to improve the current account balance and funding needs and provide a buffer for foreign owners of local-currency debt when global real rates rise

China

A successful deleveraging of local governments and large enterprises while levering up consumers and small/medium enterprises. Dealing with deflation, excess capacity and NPLs: Monetary easing to stabilize growth, reduce funding costs, take the pressure off local rates and foreign exchange (Recognizing NPLs and reducing excess capacity will help reduce deflation and real rates.) Reforms for state-owned enterprises (SOEs), government agencies and the financial sector A transition of China’s economy into a more consumption and services-driven one is critical to further multiple expansion Further increased weight of New China companies, which have higher and improving returns on equity (ROE) Improvement in China banks’ ROEs as their NPL recognition peaks

India Progress on reforms in the area of taxation, infrastructure, SOE banks, agriculture and labor Improvement in ease of doing business from lowest ranking among EM economies in order to aid industrialization Productive investment cycle thanks to lower deficit, falling inflation and policy rates

Korea Materialization of "Choinomics" agenda: Corporate/tax reforms and fiscal easing to help the domestic economy Maintenance of global market share via continued focus on research and development; favorable REER trend Deal with deflation and debt: Policy easing to raise CPI and PPI trajectory and reduce real burden of debt

Indonesia Solve Dutch Disease problem: Lift noncommodity exports, lower REER, incentivize manufacturing Education and infrastructure development to improve the quality of human and physical capital Reindustrialization to regain growth momentum, raise share of high-value goods in exports

Russia Sanctions removal through geopolitical progress; recovery in oil price Structural reforms of pension system, media rights and judicial system Privatization to increase efficiency of SOEs and the broader economy

Turkey Improve the quality of funding: Increase savings by reducing current account deficit, less reliance on portfolio flows. Structural reforms to develop domestic savings and reduce the current account deficit.

S. Africa

Twin deficits improvement: Improvements in the current account and the fiscal balance; slowing down debt growth Infrastructure: Better provision of utilities/electricity and water; road, rail, infrastructure upgrades Liberalization of the labor market and more education: Increase flexibility; curb unrest; raise human capital Reduction in the cost of credit: Not just cutting policy rates, but addressing institutional frictions that keep credit costly

Brazil

Tightening of fiscal and quasifiscal policy: Stick to fiscal adjustment plan, raise long-term interest rate; tax simplification Labor market reforms: Unemployment insurance and end of payroll tax-break bill approved by Congress Current account balance improvement: Improve domestic savings both public and private Gain in competitiveness in the manufacturing sector, driven by declining REER via labor market weakness and foreign exchange

Mexico Realize gains from energy reform to attract investment from private sector to fill in the potential gap in energy investment left by austerity measures; watch for success in auctions Response to security-cum-political crisis: Monitor the success of the new anticorruption system

Source: Morgan Stanley Research as of March 15, 2015

ON THE MARKETS / FIXED INCOME


SUZANNE LINDQUIST Fixed Income Strategist Morgan Stanley Wealth Management

he huge drop in oil prices is among the most significant forces in the

global economy, and it reverberates in multiple financial markets, including corporate bonds. Not surprisingly, companies that benefit from lower oil prices, such as airlines and shippers, should enjoy enhanced cash flows, and thus their bonds are more attractive. The flip side, of course, is that oil producers face reduced cash flows and some, especially among high yield issuers, may have difficulties and could possibly see downgrades of their credit ratings.

MARKET COMPOSITION. In the chart (below), we illustrate the composition of the industrial sectors of the Barclays US Investment Grade Corporate Index and the Barclays US Corporate High Yield Index by the percentage of the index represented by each industry. While the industrial

sector comprises 60% of the investment grade index, it is 86% of the high yield index. We also color-code the sectors by our investment assessment, from most favorable to least favorable.

As would be expected, transportation is a high-conviction sector, as it wins big on lower fuel costs. Still, even if the sector’s bonds make good price gains, it won’t make a big impact on the overall market; airlines, railroads, truckers and maritime shippers are just 4% of investment grade industrials and 2% of high yield industrials. Poor performance by energy sector bonds would have a much greater impact on the market since energy is 18% and 16%, respectively, of the investment grade and high yield industrial sectors.

CONSUMER SECTORS WIN. Less obvious, perhaps, is that both cyclical and noncyclical consumer industries look better under a low-oil scenario. Consumer cyclical industries, such as restaurants,

will likely benefit. This is especially true for fast-food chains, whose lower-income customer tend to see the biggest increase in disposable income from lower gas prices. Selected travel and leisure indus-tries should benefit as “drive to” entertain-ment demand increases. Specifically, higher occupancy rates for select hotel brands, higher ticket purchases for theme parks and more dollars spent in casinos will bode well for those sectors. Among the noncyclical consumer sectors, processed-food manufacturers stand to gain from lower oil prices because they spend 10% to 15% of the cost of goods on freight and fuel.

While low oil prices are a drag on most energy companies, some companies are less vulnerable. To wit, we believe midstream-pipeline companies should perform well. These companies own and operate essential, long-lived assets and generally have steady, recurring, fee-based cash flows. Since they get a fee for transporting volume, they are generally not directly affected by commodity price changes. The midstream pipelines serve to show investors they need to look at fundamentals and financial statements before making a blanket judgment.

Assessing Oil’s Impact On Corporate Bonds

T

Energy Prices Have Varying Effects on Corporate Bond Sectors

Source: Barclays, Morgan Stanley Wealth Management as of March 31, 2015

Basic Industry

9%

Energy18%

Tech10%

CapitalGoods

8%Communications

16%

ConsumerCyclical

11%

ConsumerNoncyclical

24%

Transportation4%

Barclays US Investment Grade Corporate Index, Industrials

BasicIndustry

10%

Energy16%

Tech7%

CapitalGoods

10%Communications22%

ConsumerCyclical

17%

ConsumerNoncyclical

16%

Transportation2%

Barclays US Corporate Yield Index, Industrials

Most Favorable

LeastFavorable

ON THE MARKETS / FIXED INCOME


JOHN DILLON Municipal Strategist Morgan Stanley Wealth Management

uring the past few months, global markets have ebbed and flowed, with

the two primary drivers being a potentially tighter monetary policy in the US and subpar growth triggering rate cuts most everywhere else. Also in the mix have been declining oil prices, widespread negative interest rates abroad and inflation that is thus far well-anchored.

Against this backdrop, the relative-value ratio of tax-exempt municipals has remained elevated, in the range of 95% to 106% for benchmark 10-year securities (see chart). That means investors can purchase a top-grade tax-exempt bond at essentially the same interest rate as a taxable US Treasury bond.

MUNI MARKET FORCES. The dynamic works like this: During periods of sharp gains in US Treasury prices—there have been two already this year—tax exempts often have difficulty keeping pace, and that drives relative value higher. Investors should consider capitalizing on these favorable entry points when they arise. Not all are a result of the Treasury market fluctuations. Sentiment plays a role, as does muni market supply and demand. Right now, the par amount of maturing munis is relative lowly, which lowers reinvestment demand, but the 30-day visible is near its highest year-to-date reading. Inflows to municipal bond mutual funds, a source of demand, right now is only mildly positive.

Perhaps because of anxieties of rising rates and other concerns, some investors

have stood aside and earned virtually nothing on their cash during the past five years. Those who remained invested have been “paid to wait” each and every year. They have continued to collect their coupon, and many have benefited from the increase in bond prices as interest rates declined. Concerns in the muni sector primarily center on long rates that have not yet spiked on a sustained basis and public-pension underfunding that will likely endure for years to come. The potential for tax reform that could affect the bonds’ tax status also remains in the background, even if the politics of tax reform make it unlikely.

TAX CONSIDERATIONS. What is real—and imminent—is taxes and the April 15 tax-filing deadline. With a 39.6% top federal tax rate, the Medicare surtax and many higher state tax rates, investors with the highest combined federal, state and local taxes—residents of California, Washington DC, Hawaii, Iowa, Minnesota, New Jersey, New York, Oregon and Vermont among them—in many cases would require nearly twice the yield on a fully taxable bond to match the tax-free yield of in-state municipal paper.

As for purchases, we retain our 10-to-15-year focus range and see value in adding floating-rate notes along with some cash for flexibility. We favor A-rated general-obligation bonds and BBB-rated essential-service revenue bonds, stressing bonds with coupons above today’s market rates.

Muni Investors Get Paid to Wait

D

Relative-Value Ratio Makes Muni Bonds Attractive Versus Comparable US Treasuries

*Yield on 10-year AAA general-obligation bond as a percentage of the yield on 10-year US Treasury bond Source: Thomson Reuters Municipal Market Data as of March 31, 2015

80

85

90

95

100

105

110

115%10-Year Relative-Value Ratio*

ON THE MARKETS / Q&A


ith yields at or near historic lows for many years now, US Treasuries

continue to remain expensive. On the other hand, whenever US interest rates start to edge higher, foreign investors and the “flight to quality” have resulted in big inflows to bonds, which, in turn, pushes Treasury yields lower. Such a risk-on, risk-off environment doesn’t make it easy to navigate the bond market, says Doug Peebles, chief investment officer and head of fixed income at AB (formerly known as AllianceBernstein). Peebles recently spoke with Lisa Shalett, head of investor and portfolio strategies for Morgan Stanley Wealth Management, about where he is finding attractive opportunities and why bonds remain critical to diversification—even if yields are low. The following is an edited version of their conversation.

LISA SHALETT (LS): How do you assess the global fixed income market today?

DOUG PEEBLES (DP): Quality assets have become scarcer. Many of the quality assets of years ago—French and German bonds, the Swiss franc, gold and, of course, Treasuries and the US dollar—have fallen off the list because of the risk involved or because central banks changed policy and lessened their quality. Still, they are expensive. Prices go up [and yields go down] when people are afraid, so I think fixed income assets are going to become even more expensive.

Even so, you still need to buy expensive fixed income assets because, to gain diversification, you need assets that are not correlated with equities. Some investors say the yields are low on US Treasuries and German Bunds so they buy high yield bonds or emerging market debt. There’s

nothing wrong with either, but they don’t help achieve diversification. The high yield market, in particular, is more correlated to the equity market than to the US Treasury market.

Instead of just buying 10-year US Treasuries at expensive levels, the best way capture that risk-mitigating portfolio is by buying global bonds on a hedged basis. We think it’s a great idea to separate the decision to buy the bond asset from the decision of whether you need to have that currency in your portfolio.

In the return-seeking space, we haven’t liked emerging market debt much; however, they’ve gotten beaten pretty hard and are starting to look a bit cheap to us on a real effective-exchange-rate basis—but I don’t think investors should be buying the Indonesian rupiah or Mexican peso as flight-to-quality assets.

LS: What is your perspective on municipal bonds?

DP: I think the opportunity in munis is still very much available. There are more bonds being issued, and many are refinancings. From a credit perspective, that makes the debt profile more affordable.

The other point is that revenues at the state and local levels have picked up. One of the reasons the Fed is probably on a path to changing policies is the employment situation. We can argue about wages, but there have been millions of jobs created and that has benefited the tax structure and tax receipts of many states.

I think last year’s performance in the muni market was because of the severe muni spread widening we had seen the prior year with both Detroit and Puerto Rico. While it didn’t take that much credit

research to figure out that Detroit was going to be a problem—its revenues had been shrinking for years—from time to time we’re going to have those big problems. Proper research can identify them, and that’s why we think muni bonds should be professionally managed. If investors need more income, the high yield muni market still looks attractive to us.

LS: How are you thinking about bonds in the energy sector?

DP: I think the most vulnerable credits are those that borrowed money based on a highly levered business model that the fracking and the specific exploration and production would, in aggregate, lift all boats. But this is a complicated process in which individual companies have overextended themselves based on a linear projection of the oil that will be tapped by these new technologies—and it’s anything but linear.

Typically, the marketplace lumped all energy together, and that was a mistake. Now it’s again lumping all energy together and selling off en masse. This is going to take longer to play out. There’s probably some unsophisticated money chasing the energy play and assuming there’s going to be significant recovery value. That will be the case for certain issuers, but you have to do your homework on the companies and also on the technologies being utilized—looking out to the future [to see] that the tapping and receipt of those energy supplies will be stable.

The additional complicating factor is the price of oil. I would say a central forecast right now has to be very, very wide. If you’re trying to make a play on oil, this is probably not the best way to do it because, if you’re wrong, the potential price drop in some of these securities still has a way to go and there’s not a lot of liquidity to change your mind. I think the best forms of investment in this space are locked-up money as opposed to very liquid money.

Buying Bonds in a Brutal Market

W


LS: Staying with the distressed theme, how do you think the Greece situation will play out? How far into the periphery of Europe do you fish?

DP: There is a lot of politics involved with the Greece situation. The recently elected anti-Troika rebels would actually have a more powerful hand to play if the regulators and broad policymakers in Europe were worried that contagion might impact Spain, Italy and Portugal in short order, but those countries don’t have elections due to come up in a short enough time frame.

Looking at pure economics, you wouldn’t buy Greek bonds because the country’s debt is too large relative to its ability to pay it back, but the first restructuring of Greek debt did term out the loans for a long period with very low interest rates. Now it’s about whether the new administration is willing to make the changes the European Central Bank (ECB), the EU and probably the IMF want it to make, and the government could run out of money in the meantime. I also think the economy could still drop further if Greece were to attempt to leave the Euro Zone.

We own some other European peripherals, and I go to that notion of the price-insensitive buyer. The ECB has only been in the marketplace for a day and prices have reacted to that. I think it’s going to be complicated by the fact that Europe is actually going to benefit from a cyclical recovery in a bad structural story. The drop in the euro, combined with the fall in energy prices and the ECB’s action, form a nice backdrop for Europe, regardless of its dysfunctional structural situation.

LS: What about emerging markets? How are you navigating those?

DP: You used to be able to lump all emerging markets together; when Mexico had its peso crisis and when Russia defaulted in 1998, it didn’t matter what country you owned—they all fell alike. Over the past several quarters, the market is throwing all these emerging market currency exposures into the same basket.

I don’t think that’s fair. So to us, a country like Mexico is starting to look attractive because it is being treated by the market as two bad things: it’s an energy play, and it has the most liquid emerging market currency. People are just shorting that because they have exposure to emerging markets in general and have probably gotten beaten up a bit too much. I think the Mexican central bank was in the market today intervening to try to strengthen the peso.

Also, countries like Indonesia have very high real interest rates. I think there are individual plays to be made, but the outlook for many of these economies is still not very good. We want to gain exposure to those countries that will participate at least for a cyclical swing in what we think is a stronger-than-consensus view on the US, as well as that cyclical pickup in the Euro Zone.

Even though we’ve been very far away from those plays, it’s time to start looking because they’ve gotten so cheap. When emerging market currencies get cheap, they become attractive in two ways: the on-the-spot exchange rate, and in terms of the forward market. The market not only is afraid of a continuation of a fall in the spot rate, but it projects that out into the future. So the forward foreign exchange rate—essentially what the foreign exchange market indicates as its view of the interest rate differential into the future—also blows out way too much.

We like to invest in these markets when the spot is cheap and the forward market is also pricing into the future a continuation of that cheapness trend. That usually doesn’t occur.

LS: Is there anything you’re concerned about that investors may not be paying attention to?

DP: Yes, this notion of liquidity risk. As advisors, we spend a lot of time in our careers managing and understanding duration risk, credit risk, currency risk and even prepayment and volatility risk when we think about the mortgage market. The risk that’s the newest to all of us is liquidity risk.

Take the high yield bond. All high yield bonds aren’t exactly stellar credits—that’s why you need portfolio diversification—but you used to be able to break down the differential between the yield you got on high yield and the yield that was available in Treasuries, and that spread was the compensation you got for taking the default risk.

We’re seeing more that a big component of that spread has to be made up for the liquidity risk. The Wall Street Journal and the like are on top of this drop in liquidity in these markets, and it’s being treated like a bad thing all the time. We need to think about, “How do I manage this risk just like I would duration, credit or currency, and how do I profit from it?” There’s not much history to tap there.

Doug Peebles is not an employee of

Morgan Stanley Wealth Management. Opinions expressed by him are solely his own and may not necessarily reflect those of Morgan Stanley Wealth Management or its affiliates.

ON THE MARKETS / STRATEGIES


LISA SHALETT Head of Investment and Portfolio Strategies Morgan Stanley Wealth Management ZACHARY APOIAN Senior Asset Allocation Strategist Morgan Stanley Wealth Management

nvestors today face an increasing number of choices for adding exposure

to equities. Historically, actively managed funds have been the overwhelming favorite. The concept is enticing: In exchange for a fee, individuals can hire professional managers to select securities and construct diversified portfolios in hopes of beating the market. This so-called active management could be particularly effective in times of market stress and downturns, when more-focused stock selection can reduce the damage that might be inflicted by exposure to the broad index. Of course the effectiveness of active management would be dependent on manager skill and their ability to select better performing investments.

Recently, however, periods in which active managers underperformed and increased focus on costs has prompted growth in passively managed products. These typically charge lower fees but abandon the goal of outperformance, instead attempting to merely keep pace with the market. Providers of these indexed or passive products argue that, over time, market efficiency inhibits the efficacy of active managers.

ASSESSING PORTFOLIO DESIGN. During the past 30 years, scores of academic studies have argued for the superiority of either approach, with few definitive conclusions for portfolio construction. The result has been that most

investors and advisors have adopted a philosophical approach to their portfolio design, choosing either a largely passive approach or a largely active approach based on intuitive presumptions about market efficiency in a particular asset class. Given the impact that performance differentials and fees can have over long time horizons, these choices can have a material impact on client investment outcomes. In that spirit, the Global Investment Committee (GIC) recently embarked on a proprietary study to assess whether a more dynamic approach to portfolio-construction decisions between active and passive strategies was worthwhile.

Our current model, based on data through February 2015, suggests that optimal allocations for the next year lean

passive, except for even splits in small-cap growth and small-cap blend, and include an active tilt for mid-cap growth (see chart). We plan to rerun the model every month and anticipate that annual turnover in recommendations will be less than 30%.

In allocating between active and passive strategies, we couple our model-driven view of the current environment with the long-term performance of active strategies across styles. The model recommends being fully active when the environment is most attractive, fully passive when least attractive and more balanced when moderate.

INSIDE THE MODEL. We develop the model by fitting historical standardized factor values within each of the nine size (large/mid/small) and style (growth/blend/value) boxes, against the proportion of managers outperforming during the following four quarters. We then utilize the model by estimating the proportion of active managers that we expect to outperform based on historically realized proportions during the backtest period when factors have been of comparable attractiveness. Recommend-ations allocate within each size/style box to active and passive funds in a means

Active and Passive Strategies: An Opportunistic Approach

I

How We Are Allocating Between Active and Passive Equity Managers

Source: Morgan Stanley Wealth Management GIC as of Feb. 27, 2015

25%Active

25%Active

75%Active

25% Active

50% Active

25%Active

25% Active

75%Passive

100%Passive

75% Passive

25% Passive

100% Passive

75%Passive

50% Passive

75%Passive

75%Passive

Large-CapGrowth

Large-CapBlend

Large-CapValue

Mid-CapGrowth

Mid-CapBlend

Mid-CapValue

Small-CapGrowth

Small-CapBlend

Small-CapValue

Suggested Allocation to Active and Passive Managers by Style Box,Based on Expected Percentage of Active Managers Outperforming


consistent with maximizing expected relative return.

To assess the market environment, the model looks at nine factors and assigns ratings to them depending on how they affect growth, blend or value investment styles (see table). The factors are:

Return Correlation. Markets with low return correlation among stock returns are synonymous with a “market of stocks,” and are ideal for managers attempting to outperform through security selection. In contrast, in markets with high return correlation, stocks tend to move in tandem, which is a difficult environment for active managers.

Valuation Dispersion. Near-term valuation dispersion measures the difference between “attractive” and “expensive” companies and compares the current difference with what has been observed historically. High valuation dispersion suggests that investors are discriminating among companies with different earnings achievability. When valuation dispersion is low, the market is pricing all companies similarly. In periods of wide valuation dispersion, companies in which there are concerns about short-term earnings growth trade at deeper discounts, which creates larger opportunities for active managers.

Deep-Value Dispersion. Similar to near-term value, this measure looks at the current spread between attractive and expensive based on price/book value, and then compares this spread with its history. Periods with wider spreads benefit value managers, and, similar to near-term value, tend to occur during periods of elevated market stress.

Earnings-Estimate Dispersion. Earnings-estimate dispersion attempts to measure the prevailing level of controversy among analysts. Similar estimates of company earnings by sell-side analysts create little opportunity, but widespread differences among estimates provide more opportunities to earn alpha related to the surprise from resolving uncertainty.

Flows to Active Funds. Fund liquidity creates asset movement in and out of funds that, at times, may be beneficial or disruptive for active managers. Here, we focus on growth and blend managers whose portfolios include both growth and value stocks. As flows enter these funds, managers continue to buy consensus favorites and perpetuate their outperformance. This argument is less relevant within value, where other characteristics tend to generate outperformance. Based on this, we do not use fund flows for the value style.

Return Dispersion. Return dispersion is a formalized measure of the performance spread in equities. In periods in which there are greater differences in realized return between the best- and the worst-performing stocks, active managers are better able to beat their benchmarks. Markets can display high return dispersion, such as during the recovery from the 2009 credit crisis, when deep-value and low-quality names dramatically outperformed their higher-quality and growth counterparts. In contrast, recent markets have seen much smaller differences between outperforming and underperforming styles.

Yield-Curve Slope. An unusually flat yield curve signals an outsized chance of

recession and suggests complacency among market participants. This raises the likelihood of market corrections. During market turbulence, active funds typically outperform due to an overweight of high-quality companies, leading to superior performance in market declines. Because of this, a flatter yield curve is expected to benefit active managers across styles.

Recent Active-Manager Success. We have observed that periods that favor both active and passive managers tend to persist, often for several years. Because of this, an indication of the environment for active performance is the performance itself. If managers have outperformed in the immediate past, they are likely to continue outperforming in the immediate future. We can use the percentage of managers outperforming explicitly to forecast potential outperformance.

Also contributing to this report were

Partap Singh Ahuja, Tucker Johnston and Matthew Rizzo.

For a full copy of the white paper, “Active and Passive Strategies: An Opportunistic Approach,” please contact your Financial Advisor.

Different Indications Provide Pieces of the Attractiveness Puzzle

Source: Morgan Stanley Wealth Management

Indication Why Does This Help?

Shifting Yield-Curve SlopeActive managers position for many investment themes, while benchmarks depend on only growth or value; risk aversion shifts, which are visible in yield curve slope changes, lead to passive outperformance

Higher Deep-Value Dispersion

Differing returns raise the reward for owning outperformersHigher Return Dispersion

Lower Return Correlation Stock selection is more effective when companies trade distinctly

Higher Near-Term Value Dispersion

Greater differences in prices versus next year's earnings signals exploitable uncertainty

Larger gaps between "attractive" and "expensive" prices versus book values suggests actionable neglect of deep value

Flat Yield Curve Signals elevated chance of market correction; active benefits due to quality bias

Recent Active- Manager Success Favorable periods for active managers have demonstrated persistence

Higher Earnings- Estimate Dispersion

Controversy among analysts allows for benefit from research-driven "surprise"

Higher Flows to Active Funds Inflows perpetuate success of consensus growth favorites


Global Investment Committee Tactical Asset Allocation

The Global Investment Committee provides guidance on asset allocation decisions through its various model portfolios. The eight models below are recommended for investors with up to $25 million in investable assets. They are based on an increasing scale of risk (expected volatility) and expected return. Hedged strategies include hedge funds and managed futures.

Source: Morgan Stanley Wealth Management GIC as of March 2, 2015

MODEL 1

MODEL 2 MODEL 3

MODEL 4

MODEL 5 MODEL 6

AGGRESSIVE

MODEL 7 MODEL 8

53% Investment Grade Fixed Income

29% Cash

3% Emerging Markets Fixed Income 1% Inflation-

Linked Securities

14% High Yield

3% Emerging Markets Equity


15% International Equity

12% US Equity

14% Cash

6% Hedged Strategies and Managed Futures

8% High Yield

2% REITs

2% MLPs

1% Emerging Markets Fixed Income



16% US Equity

9% Cash


2% Commodities

6% High Yield

2% REITs 1% Emerging Markets Fixed Income



20% US Equity

4% Cash


3% Commodities

3% REITs

5% High Yield



24% US Equity

3% REITs

4% High Yield


3% Commodities

2% Cash

1% Cash

28% US Equity






2% High Yield

3% REITs


4% MLPs

32% US Equity



3% REITs

4% Commodities


3% Cash


4% Commodities

3% REITs

26% US Equity



CASH

GLOBAL FIXED INCOME

GLOBAL EQUITIES

ALTERNATIVE INVESTMENTS

KEY

MODERATE

CONSERVATIVE MODERATE >>>

>>>

>>>

>>>

>>>


1% Commodities 3% MLPs

3% MLPs 4% MLPs 4%

Commodities

4% MLPs 4% MLPs


Source: Morgan Stanley Wealth Management GIC as of March 31, 2015 *For more about the risks to Master Limited Partnerships (MLPs) and Duration, please see the Risk Considerations section beginning on page 18 of this report.

Tactical Asset Allocation Reasoning

Global Equities Relative Weight Within Equities

US Overweight While US equities have done exceptionally well since the global financial crisis, they still offer attractive upside potential, particularly relative to bonds. We believe the US and global economies continue to heal, making recession neither imminent nor likely in 2015. This is constructive for global equities, including the US.

International Equities (Developed Markets)

Overweight We maintain a positive bias for Japanese and European equity markets given the political and structural changes taking place in Japan and our expectation for an improving economic outlook in Europe. European and Japanese central banks are now engaged in much more aggressive monetary policy than the US. Europe and Japan are also moving away from fiscal austerity, which should be relatively more stimulative for growth on a rate-of-change basis.

Emerging Markets Underweight Emerging market (EM) equities have been a mixed bag for the past few years and we expect that to continue. We remain underweight the broader region as many countries go through a necessary rebalancing of growth. Furthermore, the Fed’s rate hike cycle began with the tapering of Quantitative Easing last year and is likely to lead to further US-dollar strength as the Fed raises rates this year—another negative for the EM region broadly. We recommend investors take a narrower approach, focusing on oil-importing countries such as India, China, Taiwan, Korea, Malaysia and the Philippines.

Global Fixed Income

Relative Weight Within Fixed

Income

US Investment Grade Overweight We have recommended shorter-duration* (maturities) since March 2013 given the extremely low yields and potential capital losses associated with the rising interest rates. We have subsequently reduced the size of our overweight in short duration as we expect short-term interest rates to move higher as the Fed moves toward its first rate hike. Within investment grade, we prefer BBB-rated corporates and A-rated municipals over US Treasuries.

International Investment Grade

Equal Weight Yields are low globally, so not much additional value accrues to owning international bonds beyond some diversification benefit.

Inflation-Linked Securities

Underweight We have been underweight inflation-linked securities since March 2013 given negative real yields across all maturities. Recently, these yields have turned modestly positive but remain unattractive, in our view, due to the longer-duration characteristics of TIPS and limited risk for unexpected inflation.

High Yield Overweight The sharp decline in oil prices has created some dislocations in the US high yield market. Broadly speaking, we believe default rates are likely to remain muted as the economy recovers slowly, keeping corporate and consumer behavior conservative. We prefer shorter-duration and higher-quality (B to BB) issues and vigilance on security selection at this stage of the credit cycle. With energy-related issues, investors need to be very selective until the price of crude oil stabilizes.

Emerging Market Bonds

Underweight Similar to emerging market equities, we remain underweight on the basis that the beginning of the Fed’s rate hike cycle will likely be a disproportionate headwind for emerging market debt relative to other debt markets.

Alternative Investments

Relative Weight Within Alternative

Investments

REITs Equal Weight Falling interest rates led to very good performance for REITs in 2014. At current levels, we believe REITs are fairly valued and offer more select opportunities. The industrial and commercial segments tend to outperform at this stage of the recovery. Non-US REITs should also be favored relative to domestic REITs at this point.

Commodities Equal Weight Most commodities have underperformed in the past few years, with energy leading the charge lower. While commodities look more attractive at this point as a diversifier against potential geopolitical shocks, the fundamental case keeps us with an equal-weight tactical recommendation.

Master Limited Partnerships*

Equal Weight Master limited partnerships (MLPs) should continue to do well as they provide diversification benefits to traditional assets and a substantial yield that is valuable in a low interest rate world. Many MLPs are levered to commodity consumption, which is more predictable than prices. The recent sell-off in crude oil prices has created some good opportunities in MLPs with midstream assets like pipelines.

Hedged Strategies (Hedge Funds and Managed Futures)

Equal Weight This asset class can provide uncorrelated exposure to traditional risk-asset markets. It has outperformed equities when growth has slowed and has worked well in more challenging financial markets.

ON THE MARKETS


Index Definitions BARCLAYS US INVESTMENT GRADE CORPORATE INDEX This index represents mainly investment grade US corporate bonds. BARCLAYS US CORPORATE HIGH YIELD INDEX This index captures the performance of the below-investment grade debt issued by corporations domiciled in the US and Canada. EURO STOXX INDEX This index is made up of the 50 largest and most liquid stocks in the Euro Zone equity markets. HANG SENG INDEX This is a free-float-adjusted, capitalization-weighted index of the Hong Kong Stock Market. HANG SENG CHINA ENTERPRISES INDEX This is a free-float-adjusted, capitalization-weighted index of the “H shares,” which are shares of mainland China companies that trade in Hong Kong. MSCI AUSTRALIA INDEX This is a free-float-adjusted, market-capitalization-weighted index designed to measure performance of Australia-based equities.

MSCI CANADA INDEX This is a free-float-adjusted, market-capitalization-weighted index designed to measure performance of Canada-based equities. MSCI CHINA INDEX This is a free-float-adjusted, market-capitalization-weighted index designed to measure performance of China-based equities. MSCI FRANCE INDEX This is a free-float-adjusted, market-capitalization-weighted index designed to measure performance of France-based equities. MSCI GERMANY INDEX This is a free-float-adjusted, market-capitalization-weighted index designed to measure performance of Germany-based equities. MSCI JAPAN INDEX This is a free-float-adjusted, market-capitalization-weighted index designed to measure performance of Japan-based equities. MSCI SWITZERLAND INDEX This is a free-float-adjusted, market-capitalization-weighted index designed to measure performance of Switzerland-based equities.

MSCI UNITED KINGDOM INDEX This is a free-float-adjusted, market-capitalization-weighted index designed to measure performance of UK-based equities. MSCI USA INDEX This is a free-float-adjusted, market-capitalization-weighted index designed to measure equity market performance in the US. NASDAQ COMPOSITE INDEX This is a capitalization-weighted index of more than 3,000 common equities listed on the Nasdaq exchange. NIKKEI 225 AVERAGE This is a price-weighted average of 225 stocks that trade on the Tokyo Stock Exchange. SHANGHAI STOCK EXCHNAGE A-SHARES INDEX This is a market-capitalization-based index of all A-shares trading on the Shanghai Stock Exchange. S&P 500 INDEX Regarded as the best single gauge of the US equities market, this capitalization-weighted index includes a representative sample of 500 leading companies in leading industries in the US economy.


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.

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.

Managed futures investments are speculative, involve a high degree of risk, use significant leverage, have limited liquidity and/or may be generally illiquid, may incur substantial charges, may subject investors to conflicts of interest, and are usually suitable only for the risk capital portion of an investor’s portfolio. Before investing in any partnership and in order to make an informed decision, investors should read the applicable prospectus and/or offering documents carefully for additional information, including charges, expenses, and risks. Managed futures investments are not intended to replace equities or fixed income securities but rather may act as a complement to these asset categories in a diversified portfolio. 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. 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. Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. 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. 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. The initial interest rate on a floating-rate security may be lower than that of a fixed-rate security of the same maturity because investors expect to receive additional income due to future increases in the floating security’s underlying reference rate. The reference rate could be an index or an interest rate. However, there can be no assurance that the reference rate will increase. Some floating-rate securities may be subject to call risk.

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. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

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.

Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies. 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 Smith Barney LLC retains the right to change representative indices at any time. 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. 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 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. 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. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Credit ratings are subject to change. 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: Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. 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 may allow clients and Financial Advisors to obtain a sense of the risk/return trade-off of different asset allocation constructs.

Disclosures 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 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 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. Indices are unmanaged. An investor cannot invest directly in an index. Any indices are shown for illustrative purposes only and do not represent the performance of any specific investment. Please consider the investment objectives, risks, charges and expenses of the mutual fund(s) or ETF carefully before investing. The prospectus contains this and other information about the fund(s). Your client should read the prospectus carefully before investing. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice. Each client should always consult his/her personal tax and/or legal advisor for information concerning his/her individual situation and to learn about any potential tax or other implications that may result from acting on a particular recommendation. This material is disseminated in Australia to “retail clients” within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813). Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the material in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities. If your financial adviser is based in Australia, Dubai, Germany, Italy, Switzerland or the United Kingdom, then please be aware that this report is being distributed by the Morgan Stanley entity where your financial adviser is located, as follows: Australia: Morgan Stanley Wealth Management Australia Pty Ltd (ABN 19 009 145 555, AFSL No. 240813); Dubai: Morgan Stanley Private Wealth Management Limited (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at Professional Clients only, as defined by the DFSA; Germany: Morgan Stanley Private Wealth Management Limited, Munich branch authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Bundesanstalt fuer Finanzdienstleistungsaufsicht; Italy: Morgan Stanley Bank International Limited, Milan Branch, authorized by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, the Banca d'Italia and the Commissione Nazionale per Le Societa' E La Borsa; Switzerland: Bank Morgan Stanley AG regulated by the Swiss Financial Market Supervisory Authority; or United Kingdom: Morgan Stanley Private Wealth Management Ltd, authorized and regulated by the Financial Conduct Authority, approves for the purposes of section 21 of the Financial Services and Markets Act 2000 this material for distribution in the United Kingdom.


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 of the Municipal Advisor Rule. 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.

This material, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC. © 2015 Morgan Stanley Smith Barney LLC. Member SIPC.

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