November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1

M O R G A N S T A N L E Y R E S E A R C H

Global Cross-Asset Strategy Group

Morgan Stanley & Co. Inc.

Gregory Peters [email protected]

+1 212 761-1488

Jason [email protected]

+1 212 761-7893

Please see page 2 for full list of members

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We move from full ‘risk-on’ to a more balanced risk on / off view. All three of our market pillars —

US growth, Europe sovereign risk, and the China ‘Goldilocks’

scenario —

were flashing green for risk-

on a few weeks ago. The constructive view was driven by the mantra “don’t fight the Fed.”

That hasn’t changed for the US. But the high likelihood that Ireland will go to the EFSF fund and the contagion risk that this poses for the euro periphery is a risk-off signal, in our view. And China is less supportive for risk-on, as rising inflation will trigger policy tightening.

Recent price action suggests US growth may be better than expected, countering the downside risks. The sharp rise in US Treasuries over the past two weeks —

the 10Y is up over 40bps —

is due entirely to real rates; inflation expectations have declined.

Add to that the US dollar rally, and the market may be expecting stronger real growth, a view shared by our economists. This may also indicate that growth has taken over from QE as the main market driver. In our view, this upside risk is enough to balance out the increased downside risks elsewhere.

While we’ve dialed back our constructive view on risky assets considerably, we still see near-term upside. The probability and magnitude of a correction has increased because of the rise in European sovereign and EM inflation risks. Yet we view these as downside risks, not the base case. The EM over DM gap should shrink in a risk neutral environment, but we don’t expect a performance reversal in the near term.

November 16, 2010

Global Debates Playbook

Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

Shifting to Neutral on More Balanced Risks

– +GBP ●EM credit ●EM currencies ●Oil ●Commodities ●EM equities ●Europe equities ●Gold ●US credit ●EUR ●US Treasuries ●USD ●Europe credit ●German Bunds ●JPY ●

Asset Class Views

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Global Debates PlaybookNovember 16, 2010

2

Table of Contents Global Cross-Asset Strategy Group

1 Morgan Stanley & Co. Incorporated 2 Morgan Stanley C.T.V.M. S.A. 3 Morgan Stanley & Co. International plc 4 Morgan Stanley India Company Private Limited 5 Morgan Stanley Asia Limited 6 Morgan Stanley Australia Ltd 7 Morgan Stanley MUFG Securities 8 Morgan Stanley Taiwan Ltd + Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

Global Cross-Asset Strategy Market Commentary

3Global Cross-Asset Strategy Overview

7Investor Debates

8Asset Class Base Case Views

10Risk-Reward Views: Economics

Global Economics

14US

15Europe

16Japan

17China

18Asia ex-Japan

19Brazil / Latam

20India

21Russia

22Risk-Reward Views: Strategy

US Rates

23Europe Rates

24UK Rates

25EM Fixed Income

26FX

27Developed Market Equities

28Europe Equities

29Japan Equities

30Asia / GEMs

Equities

31China (and Hong Kong) Equities

32Global Corporate Credit 33Securitized Credit

34Commodities: Oil 35Global Equity Derivatives

36Global Credit Derivatives

37Volatility Across Asset Classes

38

Economics Joachim Fels3 +44 (0)20 7425 6138Dick Berner1

+1 212 761 3398Elga

Bartsch3 +44 (0)20 7425 5434Robert Feldman7

+81 3 5424 5285Takehiro

Sato7

+81 3 5424 5367Qing Wang5 +852 2848 5220Chetan

Ahya5 +65 6834 6738Gray Newman1

+1 212 761 6510

Strategy Jim Caron1

+1 212 761 1905Laurence Mutkin3+

+44 (0)20 7677 4029Rashique

Rahman3+

+44 (0)20 7677 7259Stephen Hull3+

+44 (0)20 7425 1330 Gerard Minack6+

+612 9770 1529Graham Secker3+

+44 (0)20 7425 6188Alex Kinmont7+

+81 3 5424 5334Jonathan Garner3+ +44 (0)20 7425 9237Jerry Lou5+

+852 2239 1588Greg Peters1

+1 212 761 1488Vishy

Tirupattur1

+1 212 761 1043Hussein Allidina1

+1 212 761 4150Sivan Mahadevan1

+1 212 761 1349



3

Shifting to Neutral as Increased Downside Risks Balance the Upside from QE and Growth

Greg Peters, (212) 761-1488, [email protected]

We move from full ‘risk-on’ to a more balanced risk on / off view. We’ve based our risk-reward assessment on three pillars: (1) US growth; (2) European sovereign risk; and (3) the China ‘Goldilocks’

scenario (see Exhibit 1).

All three were flashing green for risk-on a few weeks ago, though our view was driven by the mantra: “don’t fight the Fed.”

That hasn’t changed as we assess the US outlook. But the growing likelihood that Ireland will go the EFSF fund and the contagion risk that this poses for the euro periphery is a risk-off signal, in our view. The third pillar, China and EM, is also less supportive for risk-on, as rising inflation will trigger policy tightening. But the real risk is a

replay of 2008, in which overheating could lead to a hard landing.

Increased volatility is likely as markets digest news on sovereign risk and EM inflation, particularly on the policy front. The uncertainty about the fate of Ireland and the rest of the euro periphery leaves markets susceptible to large swings on any news or rumors. The same is true as investors assess the magnitude of inflation in EM and the risk of overheating. In both cases, policy is a major market driver. In Europe, containing sovereign risk depends on euro periphery governments taking tough fiscal actions and the EFSF serving as a “circuit breaker”

for systemic risk. In EM, policy-makers have to walk a fine line between tightening too little and too much. Given all this, the risk of a policy error is high, and that adds to both volatility and downside risk.

Recent price action suggests the market may be anticipating better US growth, countering the downside risks. The sharp rise in US Treasuries in the past two weeks —

the 10Y is up over 40bps —

after the Fed’s announce-

ment

on QE has caught many investors by surprise. What’s most noteworthy is that rise in yields has been entirely in real rates; inflation expectations have declined (Exhibit 2).

Add to that the US dollar rally, and the market may be expecting stronger real growth, not higher inflation, a view shared by our economists (see Trade Tailwinds: Coming Strongly in Q4, November 5).

Moreover, the nearly 20bps rise in the 2Y suggests a marginal change in the view that the Fed will be on hold indefinitely. Position unwinding likely accounts for some of the rate move post-announcement. But the markets may be transitioning from QE to growth as the main market driver. In our view, this upside risk is enough to balance out the increased downside risks elsewhere.

Exhibit 1: Two of our three market pillars have moved toward risk off…

Theme Where Do Things Stand? Risk On / Off?

US Growth •

“Don’t fight the Fed”

— growth gets a pass for a little longer Risk on

Sovereign Debt Crisis

Ireland going to the EFSF appears imminent, contagion looms Risk off

China / EM

China ‘Goldilocks’

scenario nearing an end Risk neutral

Exhibit 2: …but the sharp rise in real rates may be a signal of better growth

Source: Bloomberg, Morgan Stanley Research

1.5%

1.6%

1.7%

1.8%

1.9%

2.0%

2.1%

2.2%

2-Aug 6-Sep 11-Oct 15-Nov0.2%

0.4%

0.6%

0.8%

1.0%

1.2%10Y Inflation Expectations (lhs)10Y Real Rates (rhs)

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4

If, or When, Ireland Goes to the EFSF Is Not Sufficient to Eliminate Contagion Risk


Ireland is likely to go to the EFSF stability fund very soon… Pressure on Ireland from Germany and other eurozone

governments to restructure is mounting, driven by fears of contagion spreading through the bond markets. Likewise, the ECB is pushing Ireland to go to the EFSF because Irish banks have lost access to market funding and now rely on emergency lending support from the ECB.

If Ireland resists —

it’s funded until next summer and has a cash buffer —

or it reaches an agreement that does not include a credible bank recapitalization plan, risk-off sentiment will continue to weigh on markets.

…but that still leaves uncertainty in the credit markets and contagion risk. The ideal solution, outlined by our colleague Joachim Fels, is for Ireland to go to the EFSF, where it could borrow at a subsidized interest rate

of 4-5% and use the loan proceeds to recapitalize and restructure the banking system (see Morgan Stanley Strategy Forum, November 15).

But even in this situation, it’s not clear if the markets will fund Portugal and Spain, who don’t have similar cash buffers. In fact, banks in the euro periphery already rely heavily on lending support from the ECB (Exhibit 3).

Plans to install a permanent crisis resolution mechanism to replace the EFSF in 2013 is another market headwind. The CRM would include a government bailout facility similar to the EFSF. But the crucial

difference is that it would share the burden with private creditors in a crisis, in

the form of

voluntary maturity extension, interest-rate holidays or even haircuts. The possibility of the latter, which is apparently off the table for

now, is adding to investor anxiety about lending, even now.

The EFSF buys time, but the structural problems still must be addressed. Lending to the euro periphery now is designed to support fiscal adjustment, structural reform, and the recapitalization of banks. The dual goals are to put public sector debt on a sustainable path and to enable the country to return to private sector funding at a reasonable cost. Failure to meet these objectives in the next few years may result in a further extension of loans, but eventually the political will for doing so won’t be there. More drastic outcomes then become likely. In the near term, Exhibit 4 lists a number of events that can either mitigate or exacerbate sovereign risk, and with it risk-on sentiment.

Exhibit 3: Euro periphery banks disproportionately access ECB liquidity

Exhibit 4: Sovereign risk signposts to watch

Source: BIS, Morgan Stanley Research

0%

10%

20%

30%

40%

50%

60%

70%

Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10

ECB total liquidity provision: G IPS banks / eurozone banks Total bank assets: G IPS / Eurozone

Source: ECB, Morgan Stanley Research

Category Event Date

Ireland•

By-election for a seat in Parliament•

Presentation of detailed 2011 budget•

Budget vote

•

Nov. 25•

Nov. 28•

Dec. 7

Eurozone finances

•

Eurozone

finance ministers meeting•

EU finance ministers meeting •

Nov. 16•

Nov. 17

Crisis Resolution Mechanism

•

German proposal on future CRM •

EU Commission takes up the proposal•

mid-Nov•

mid-Dec

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5

Inflation Risk in Emerging Markets and the Policy Response Could Trigger a Replay of 2008


There are inflation parallels to 2008, but also differences. QE is the target of much criticism, particularly in Asia, which is awash in inflation fears. By some measures, commodity prices are higher than their peak in 2008 (Exhibit 5). This risks repeating the experience of 1H08, when abundant liquidity, good fundamentals, and surging commodity prices led to huge inflationary pressures in EMs. In response, policy-makers were tightening aggressively going into the global recession triggered by Lehman’s bankruptcy. The difference for EM policy-makers today is that any tightening will occur while the Fed is starting a new round of QE, which presents additional challenges.

The form, not just the magnitude, of policy tightening matters, in China. Our China economist Qing Wang believes that if China relies on rate hikes or currency appreciation, it should be fine. But if the authorities

are reluctant to allow a rapid rise in either, as has been their preference in the past, they would need to cut back

on the supply of new credit. Given the magnitude of monetary overhang (Exhibit 6), this would require a drastic cut to make a

meaningful difference in inflation expectations, which have risen with QE. That is the risk: inflation in China

tends to be tamed only after drastic credit controls, which cause more harm to the real economy than either rate hikes or CNY appreciation.

The markets may react more to what the PBoC does next than the Fed. Investors are debating whether policy tightening in EM could be the trigger to end the risk-on trade. We don’t believe that will be the case, given the still ample liquidity globally. However, as now one of the main engines of global growth, China tightening could cause a market correction, even if it helps to avoid overheating. Markets have often paused or modestly corrected following the initial Fed rate hike at the beginning of a tightening cycle, but performed well starting in about 6 months. The PBoC

may take on that role now in this cycle.

Exhibit 6: Until M1 growth returns to trend, inflation pressure will persist

Exhibit 5: The CRB commodity index is above pre-crisis high

Source: CEIC, Morgan Stanley Research


-15%

-10%

-5%

0%

5%

10%

15%

Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11-4%

0%

4%

8%

12% % Deviation of M1 from the trend (lhs)

CPI % YoY (rhs)Forecast

180

244

308

372

436

500

Jan-02 Jan-04 Jan-06 Jan-08 Jan-1010

33

56

79

102

125

148W TI US$ Per Barrel (RS)CRB Food Index (LS)CRB Com m odity (LS)



6

Our Asset Class Views Reflect the Move to Risk Neutral


We’ve dialed back our constructive view on risky assets considerably but still see near-term upside. The probability and magnitude of a correction has increased because of the rise in European sovereign and EM inflation risks. Yet we view these as downside risks, not part of our base case. The combination of QE and signs of improving US growth should continue to provide risky assets with a tailwind, but the risk-reward is more modest than a month ago.

The EM over DM gap shrinks in a risk neutral environment. Investors are starting to ask whether DM can finally outperform EM, especially

with the start of policy tightening in China. We expect the performance gap to shrink as risk is dialed back, but no performance reversal in the near term. However, it is important to differentiate between EM equities and fixed income.

Our EM equity strategist Jonathan Garner recently scaled back his overweight, roughly analogous to “sell into strength”

(see Start to Scale Back OW Equities, October 18). In contrast, our EM fixed income colleagues upgraded their view to neutral/bullish, looking effectively to “buy on dips”

(see Global EM Investor: Credit, Rates & Currencies, November 10).

Investor positioning and strategic behavior could be a near term technical headwind. Many investors are positioned with the same risk-on QE trades: short the USD and long commodities and the belly of the Treasury curve. With sovereign and inflation risks back on the table, investors are asking when the risk-on trade will end. Proactively repositioning for this outcome could itself trigger ‘risk off’

market moves. For instance, some of the recent moves in Treasury rates reflects repositioning post-QE.

Adjustments to our asset class views reflect the balanced risk on/off skew. We continue to favor equities over bonds generally. There is low upside to bonds, despite QE, and the sell-off in Treasuries last week while equities also fell is a reminder that bonds are far from risk-free. The main changes to our views over the past month, aside from a general scaling back

of risk, are:

•

USD and EUR both moved to neutral from extreme negative and positive, respectively. QE remains a headwind for the USD, whereas rising sovereign risk reinforces its safe-haven status, while weakening the EUR.

•

Commodities, while still attractive on tightening supplies, are reduced a notch on USD strength and potential EM overheating risk.

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7

Global Cross-Asset Strategy – Overview


What’s Changed: Increased downside risks, and less near-term upside

•

Global growth looks stronger than even a month ago and the global output gap is shrinking. This positive development is offset by greater risk of EM overheating

due to surging capital inflows and policy makers who may fall behind the curve in fighting inflation. This increases DM “bad inflation”

risk.

•

Sovereign risk in Europe is back, with Ireland posing contagion risks to periphery bond markets because of an undercapitalized banking system. Portugal’s weakness due to structural problems makes it likely to go to the EFSF as well.

•

Rising currency tension is a downside risk if it constrains capital flows and trade, but EM currencies, if they continue to rise, are a counter to inflation risk and ultimately help global rebalancing.

Base Case: The risk-reward outlook is balanced between risk on/off; cautiously positive on risky assets

•

QE is forcing investors out on the risk spectrum, providing support for risky assets. We expect this to continue into 2011. However, QE provides a cyclical floor rather

than a cyclical lift for the economy.

•

For markets to continue grinding higher into 1Q11, growth will become more important. The US growth outlook continues to improve to a sustainable level; 3.5% GDP in

4Q.

•

Inflation rather than deflation is more likely in the US, due to

better growth (good inflation) and partly from DM importing higher inflation from EM (bad inflation) –

the latter being a consequence of QE spilling over into EM and higher commodity prices.

•

An improving growth outlook and rising inflation expectations will favor equities over bonds, generally

•

QE is likely to affect policy in other countries, but in different forms. Only Japan and possibly the UK are likely to engage in actual QE; other countries in DM and EM will be slow in raising nominal rates, keeping real rates low. Global liquidity stays abundant well into 2011.

•

Sovereign risks in Europe remain elevated until Ireland goes to the EFSF and has a credible plan for recapitalizing and restructuring its banking system to limit contagion risk. Portugal is likely to follow Ireland. Focus returns to Spain, which will have to address its banking problems.

•

EM growth stays strong, but rising inflation and commodity prices increase the risk of overheating and odds of sharp policy tightening, repeating 2008. Capital inflows

continue to provide strong technical support for EM assets. Rising commodity prices could differentiate between

EM winners and losers based on who’s a producer versus consumer.

•

Continue to favor EM over DM, although the gap shrinks in a risk

neutral environment. No clear catalyst for a performance reversal in the near term.

Risk On/Off Skew: Neutral to negative bias

R isk O ff

N eu tra l

R isk O n

T h is M o n thL a s t M o n th

Strategic Asset Class Views

– +GBP ●EM credit ●EM currencies ●Oil ●Commodities ●EM equities ●Europe equities ●Gold ●US credit ●EUR ●US Treasuries ●USD ●Europe credit ●German Bunds ●JPY ●



8

Investor Debates

Risk on or off?

What’s the catalyst to end the ‘risk on’

trade? When will ‘risk on’

end? Has that happened already?

Will ample liquidity continue to support markets or is asset reflation

due to QE already priced?

Is evidence of improving growth enough to counter increased sovereign and EM overheating risks?

Can events in EM be the trigger for risk off even if DM growth is ok and liquidity is abundant?

US outlook & QE

What impact will QE have on the economy?

Based on recent economic data, and the increase in rates, will growth be better than expected?

Will the Bush tax cuts be extended? Is the policy gridlock in Washington a positive for the markets?

Can the Fed tolerate higher inflation and risk asset bubbles, especially given international pressure?

How significant is the potential negative feedback loop from QE (e.g., importing inflation)?

How long will investors give growth a “free pass”

before expecting to see benefits from QE?

Sovereign debt crisis

When and what will cause Ireland to go to the EFSF / IMF?

How long will the ECB continue to support Irish banks before forcing a fiscal solution?

Will Portugal quickly follow Ireland’s lead in going to the EFSF?

If Ireland goes to the EFSF, will it be a ‘circuit breaker’

by recapitalizing its banks or trigger contagion?

What form and final impact will the proposed Crisis Resolution Mechanism have?

How extensively will contagion spread to Spain? To the euro core?

China / EM overheating & FX

How at risk is China of overheating? Will tightening lead to a soft or hard landing?

How widespread is the risk of overheating across EM?

How serious will the currency war get? How likely are further capital controls?

Which countries will respond to QE by raising interest rates (and FX) and which will risk inflation?

Which countries will be the winners and losers from QE, stronger

currencies, and higher commodity prices?




9

Investor Debates by Asset Class

Rates

Why have rates across the Treasury curve gone up since the Fed announced QE details?

Will rates decline, and by how much, once the Fed starts to purchase Treasuries?

Will euro-periphery spreads continue to widen on contagion fears?

What happens to spreads in the core if a periphery country taps the EFSF fund?

With rising inflation risk in EM and large capital inflows, what

happens to credit spreads and local rates?

FX

Will the USD continue to strengthen on better growth and ‘risk off’, or weaken again on QE?

Can the EUR strengthen despite sovereign risk problems?

Will China allow the CNY to appreciate faster to fight inflation

and alleviate global pressure?

Which EM countries will try to keep their currencies from rising?

How will currency tensions be resolved? Will there be coordinated policies?

How long will the USD remain the main reserve currency? What are

the alternatives to replacing it?

Equities

Have equities fully priced in the benefits of QE? Can the rally only continue if growth improves?

Would Ireland going to the EFSF lead to a significant correction? Even if growth is still surprising to the upside?

Are EM equities at risk of a correction on tightening concerns?

Is DM more attractive than EM, given overheating concerns? Can high-beta EM fall while DM is rising?

Will multiples contract if growth doesn’t improve?

Credit

What does QE mean for corporate credit with yields already so low?

What’s the risk to credit from companies doing shareholder-friendly activities (M&A, buybacks, dividends)?

What does Basel III mean for hybrids and Tier 1 capital?

How is bank debt / RMBS affected by the mortgage foreclosure crisis and mortgage put-back problem?

Commodities

How much more will QE and lower USD drive up commodities?

With tightening supply and stronger EM growth, how high could commodities go?

Will gold continue going higher because it is an inflation hedge

against QE and a risk-off hedge?




10

Asset Classes Base Case Views


Trades•

Long front-end forward rates to benefit from rolldown

and carry with the Fed likely on hold for a while

•

Overweight the belly of the curve; the 5-10yr sector is expected to outperform, boosted by Fed purchases

•

We now like being short volatility on 5s and prefer to move our long variance trade to 30y tails

•

Long low coupon vs. high coupon in Greece, Portugal, Spain, UK (cheap insurance against contagion)

•

Long Italy, Spain, France and Belgium vs. short Portugal, Ireland, and Netherlands

•

5s to underperform on the Bund curve, 10s to outperform

•

Gain exposure to EM growth through Argentina warrants and O&G sector

•

Favor

high-beta (Central and Eastern European countries, Ukraine, Argentina) over low-beta credits

.

•

We see the 10Y trading in a range of 2.25% to 2.85% in the near term, with rates likely to fall once Fed purchases begin.

•

Fed purchases will cause the belly to outperform further as the bulk of the purchases are in the 5-10y sector. We expect the 2s10s curve to flatten close to 2.00 while the 10s30s could continue to steepen.

•

A headwind for lower rates is the negative feedback loop, driven

by higher inflation in AxJ

due to excess liquidity. Inflation could flow back to the US in

the form of higher commodity prices, but also a decline in foreign ownership.

•

We expect interest rate volatility to increase further out on the curve (30y), and to fall in the belly.

•

Reversing our underweight of euro peripheral vs. core for 3 reasons: 1) tactical trading model has its smallest underweight to peripherals for 5 quarters; 2) potential regulation of financials may support peripheral bonds;

3) downside risks to peripherals are lower for investors measured against a pan-Europe index.

•

In EM, we move our directional stance to neutral/bullish. Metrics reveal signs of stability in EM macro-fundamental trends. This development supports the case for building strategic long-side EM risk positions into 2011.

EM risk market remains short-term overbought but valuation metrics suggest more compelling entry levels.

Rates / Sovereign Credit Views

•

With improving global economic conditions contrasting with the Fed’s easing move, there may be near-term upside risks for higher-beta currencies in the G10. Our preferred currencies are CHF, GBP and SEK.

•

We are now in the final stages of USD weakness and EUR is generally trading with the core. The key risks to this call are US economic data outperforming and German data underperforming. Unless peripheral concerns begin to

have an impact upon the core, we expect that peripheral issues will not have lasting impacts upon EUR/USD, although they may increase

volatility going forward.

•

We take a cautious approach by looking for other European outperformance against the EUR. We look for CHF to be the biggest beneficiary from any concerns surrounding the Eurozone, while SEK should also benefit due to the strong fundamentals and dual surpluses of both currencies.

•

We like GBP tactically as we believe QE expectations

will continue to be priced out in the short-term leading to GBP benefit as it contrasts with the rest of the

G4 as GBP is not hampered by QE and the UK takes control of its fiscal problems.

FX Trades•

Short EUR/CHF (1.28)

•

Long EUR/USD (1.46)

•

Short EUR/SEK (8.88)

•

Long GBP/JPY (134.50)

•

Short MS Dollar Index (65.00)

•

Long MS AxJ

Index (120.00)

– +CHF ●GBP ●SEK ●KRW ●CAD ●SGD ●CNY ●NOK ●EUR ●USD ●NZD ●AUD ●JPY ●

Views

– +US duration ●EU volatility ●US volatility ●US spreads ●EM spreads ●EU curve ●EM local dur. ●EM local curve ●EU duration ●US curve ●EU spreads ●



11



Equities

•

Tactically constructive on DM and EM equities, any pullback should be modest.

•

Post-QE announcement, US growth will be the main driver for equities moving higher, while QE will continue to provide a cyclical floor to the market.

•

Elevated sovereign risk and the potential for contagion in Europe is a headwind for equities; this is likely to remain until there is some resolution with Ireland initially and then the rest of the euro periphery.

•

Rising inflation in China and other countries in AxJ, exacerbated by QE, could trigger significant tightening –

otherwise risk overheating. We would look to reduce an EM overweight given the potential for a corrective phase.

•

Longer-term, we expect DM equities to trade in a broad range for an extended period for 3 reasons: 1) that’s what usually happens after big bear markets; 2) valuations point to low returns; and 3) we expect a sub-par macro cycle.

•

Near-term, DM equities have reasonable valuations and attractive yield, but investor sentiment is reaching elevated levels.

•

Valuations are fair, particularly in Europe –

approx. 10.5x 2011 IBES P/E, earnings growth leading indicator predicting 48% earnings growth

NTM

•

High dividend yields for the S&P 500 and MSCI Europe –

comparable to the 10Y Treasury yield –

are supportive for prices as investors seek yield

•

Expect companies to start putting to work near-record cash holdings in increased dividends and buybacks, and M&A, though more so in 2011

•

Earnings forecasts for 2011 are optimistic, but haven’t increased since the spring and significant downward revisions are less likely.

•

Flows out of equities and into bonds are slowing and likely to reverse in 2011 if rates start to rise, providing a technical tailwind for equities.

•

EM equities are increasingly less attractive after a 35% return to MSCI EM since May and rising inflation and tightening risks. Valuations are in-line or slightly above long-run averages.

•

Technical support from Asia / EM funds –

23 consecutive weeks of positive flows –

but the markets are technically overbought and there is a big wave of secondary placements from corporates

in the pipeline.

TradesEurope•

Add some beta –

e.g., Financials & Commodities.

•

Superior EM growth –

Energy and Materials offer better value than Staples and Capital Goods.

•

Reliable growth stocks should be long-term winners, however value stocks should outperform in the short-

term if the market rallies.

•

Dividend strategies –

we like high and secure dividend yielders; stocks where DY > credit yield; index dividend swaps.

Japan•

Buy domestic demand super-large caps: Large has underperformed small; super-large (Core 30) has underperformed large; within the Core 30 of Topix, domestic demand stocks have underperformed.

EM•

Overweight consumer discretionary as a play on development of urban middle class and rising wages.

•

Overweight upstream Asia / EM energy

•

Underweight telecoms, utilities and healthcare

•

In China, overweight high-beta sectors –

properties, material, banks, and insurance –

and underweight transportation, consumers, auto, and technology.

Thematic•

Long Large Cap Quality

•

Long DM equities with high leverage to EM growth

•

Long Dividend Yield / Reliable Growth

ViewsEurope – +Materials ●Energy ●Financials ●Telecom ●Industrials ●Tech ●Cons Staples ●Healthcare ●Utilities ●Cons Disc ●

EM – +China ●Malaysia ●Russia ●Korea ●Taiwan ●India ●Brazil ●Indonesia ●South Africa ●Turkey ●Mexico ●



12



Credit / Spread Product

•

Generally constructive –

a low growth, low return world should keep DM credit in a relative “sweet spot,”

with a lid on egregiously credit-unfriendly actions.

•

Financials should lead the way with ongoing credit repair, especially in Europe, and benefit as banks call/tender Tier 1 paper. However, the size, timing and scope of GSE MBS putbacks

to US banks is a new headwind to credit valuations.

•

Attractive valuations and strong corporate fundamentals in non-financials provide a margin of error against higher loss rates, but volatility is likely to remain high.

•

Headwinds for credit are (1) low Treasury and Bund yields that have driven corporate bond yields to historic lows, constraining further spread repair; and (2) with low yields on QE, we see a pickup in shareholder friendly activity (i.e., moderate increase in LBOs) as likely.

•

The front end of the credit curve is more attractive based on current stage in the default cycle, spread per unit of duration, and roll down and carry.

•

Net shrinkage in supply and fund flows are positive technicals; fully invested investors and positive supply are near-term headwinds in Asia.

•

For non-agency RMBS, the market is pricing in much harsher outcomes than

the collateral is currently and expected to perform. This provides a

substantial positive convexity potential. For CMBS, the two most senior classes of the synthetic CMBX

indices, AAAs and AMs,

remain cheap to fair value, while the AJs

and below

are extremely rich

Trades•

Overweight US & Asia, neutral Europe.

•

Long Financials, and extend out the maturity curve. Tier 1 in Europe and Asia remains a core overweight.

•

Quality HY is cheap relative to low-quality IG in the US: overweight BBs

vs. BBBs. The same applies to Asia. Buy 3s5s steepeners

in selected US HY.

•

Long the HY ‘tails’

(CCCs) relative to high quality.

•

Put spread collars in iTraxx

Main and Senior Financials to play sovereign volatility. For large tail scenarios, put spreads in CDX IG and risk reversals in CDX HY.

•

Long senior tranches of non-agency RMBS (subprime and alt-A).

•

Long CMBX.3 AM and short CMBX.3 A; expect to see substantial steepening here.

•

All CLO tranches are cheap compared to the underlying; particularly bullish on CLO mezz.

Commodities

•

With refinery maintenance having peaked, we anticipate further crude draws ahead, which together with a still favorable macro environment should lift oil prices higher into year-end.

•

Our updated analysis of crude oil’s supply-side fundamentals portends falling spare capacity, which will propel prices above $100/bbl in 2011 to ration demand.

•

Agriculture prices have rallied and the corn balance is precariously tight. Prices will need to continue to move higher, to at least $6.00/bu for a

sustained period, to ration demand and add acreage. Weather is still a significant risk to wheat.

•

The weakening of the US$ has been the major factor in the current metals rally, although the impact of the strengthening in the global manufacturing sector as evident in the latest PMIs

should not be underestimated as a factor in the sustainable strength of metal and bulk raw material prices.

Trades•

Good risk/reward in being long crude, specifically Dec’11 WTI, with prices very likely to move north of $90/bbl by year-end.

•

Seek exposure to stockpiling ahead of China’s H1 production/consumption cycle, (coal and iron ore). Strong conviction on copper and nickel, avoid aluminium

and zinc.

•

Add exposure to corn (Dec’

11) but shy away from wheat as weather is the biggest driver.

•

Add gold to the precious metals basket for protection against a USD under pressure, palladium for a greater risk appetite

– +Agriculture ●Precious metals ●Oil - WTI ●Gold ●Bulk comm'd ●Base Metals ●Natural Gas ●

Views

Views– +

US HY ●CLO ●Asia Financials ●US Financials ●Asia HY ●RMBS ●EU Financials ●Asia IG ●US IG ●Europe IG ●CMBS ●Europe HY ●



13

Risk-Reward Views




14

Global Economics Risk-Reward ViewInvestor Debates

QE2: will it work? Will other DM central banks follow the Fed? How will EM policymakers react?

Global growth: merely moderating or double-dipping? Key focus on US and China trajectory in 2H 2010 and 2011.

Inflation or Deflation? What is more powerful –

deleveraging or massive monetary stimulus?

What’s in the price?

Equity and credit markets have rallied on the prospect of QE2, and, while the bond market is looking for the QE2-

consistent level of yields, the dollar has weakened.

Risky assets are pricing growth moderation, but no DD.

QE2 has raised inflation expectations from low to more moderate levels.

Signposts

After G20 summitUS Tsy

semi-annual currency reportBy 4Q PBoC

to revise up 2010 target for new bank lending (currently RMB 7.5trn) December Greece: 3rd disbursement of €

9Bn 2010-11 China currency manipulation bill to go before Senate

Joachim Fels, Manoj Pradhan, Spyros Andreopoulos (44 207) 425-6138, [email protected]

Key Indicators GDP Growth: Not Double-Dipping, Moderating

-10

-8

-6

-4

-2

0

2

4

6

M ar-00 M ar-02 M ar-04 M ar-06 M ar-08 M ar-10 M ar-12

G 10 G DP Q oQ SAARG 10 C PI YoYG 10 Policy Rate

ForecastsG 10

Source: Morgan Stanley Research

2010 2011 2012 2013–2017

Global GDPBull 5.4 5.9 5.0Base 4.7 4.2 4.4 4.1Bear 3.0 2.9 3.0

DM GDPBull 3.2 3.8 2.7Base 2.4 2.1 2.4 2.1Bear 0.9 0.9 1.4

EM GDPBull 7.9 8.2 7.4Base 7.3 6.5 6.5 6.1Bear 5.2 4.9 4.5

Global Inflation (CPI)

Bull 4.0 4.3 3.8Base 3.3 3.2 3.2 3.1Bear 2.5 2.5 2.4

Base Case / Thesis 2011 Global GDP: 4.2%Just say no to the double-dip Cyclical momentum in the Euro Area and the UK is still strong, and we are looking for a pickup in US growth next year. Fiscal tightening is less widespread than generally believed and may crowd in private spending. Importantly, with the Fed engaging in QE2, global monetary policy remains super-easy.Central banks: The Big Easy Fed, ECB, BoJ

all remain super-expansionary into 2011, and EM CBs’

ability to tighten is thus limited due to concerns about excessive currency appreciation. China is even starting to relax credit policy.Sovereign risk concerns to spread into the European core and, eventually, to migrate to the US as most governments lack resolve to tighten policy significantly. This raises the temptation to inflate away the debt.

Bull Case 2011 Global GDP: 5.4%A stronger capex

and inventory cycle could boost global output and trade. Commodity prices would skyrocket, fuelling inflation concerns and leading to more aggressive monetary tightening.

Bear Case 2011 Global GDP: 3.0%Growth in China/Asia falters in response to monetary tightening, aborting the strong global trade recovery, pushing commodity prices lower. Protectionism could also be a policy response. Fiscal positions would deteriorate further, making a large-scale sovereign risk crisis even more likely.



15

US Economics Risk-Reward ViewInvestor Debates

Double-dip and deflation fears have eased, reflecting the onset of QE2. But tail risks are not zero: Recent data have been mixed.

Policy intractability: Fiscal policy appears gridlocked, although an extension of expiring tax cuts is likely at some point. The economic impact of additional easing likely will be modest.

Sovereign credit concerns: When will spotlight turn to the US?


Near term, our trading desk does not think that QE2 is fully in the price, and yields may decline to 2.3%. Equally, with monetary policy driving yields, it is difficult to determine whether or not real yields reflect market expectations for growth. But rising breakevens do reflect some longer-term upside for inflation, something the Fed welcomes.

SignpostsNovember 15 “Lame duck”

session of Congress begins

December 3 November employment situation

December 14 FOMC meeting

Key Indicators Two Scenarios for Growth in 2011

Base Case / Thesis 2011 GDP: 2.7%Subpar growth, but consensus is too dour. Four factors will sustain growth at 2-2½% in H2: (1) a rebound in net exports; (2) solid growth in personal income; (3) a modest refinancing wave; (4) rising infrastructure spending. We still think that the US economy remains on track for moderate, sustainable growth in 2011.

QE2. We expect the Fed to announce an initial commitment to buy Treasuries at around a $100 billion monthly clip for the next six months. Going forward, the Fed likely will adopt a flexible approach to QE that can be scaled to economic and financial conditions. Nevertheless, the fractures in the monetary policy transmission mechanism mean that QE won’t yield much bang for buck.

QE2 will push nominal yields lower. We believe that the actual start of the program will trigger further significant declines in Treasury yields, especially if the Fed is as resolute as its prior rhetoric.

Bull Case 2011 GDP: 3.8%Improving income and another increase in mortgage refinancing activity should bolster household cash flows and add to discretionary spending power. Overall final demands look set to

accelerate and historically low levels of business inventories (in relation to sales) point to production gains. A rebound in inflation expectations could prompt a much more rapid exit by the Fed than

is now priced in.

Bear Case 2011 GDP: 1.6%Even larger home price declines, the “sunset”

of the Bush tax cuts, and continued moderation in job growth could weigh on growth. If the economic recovery falters, the unemployment rate will climb significantly, credit-related losses will mount, and risk aversion will predominate. These developments would reinforce deflation fears

and compel the Fed to undertake more significant QE.

Source: Bureau of Economic Analysis, Morgan Stanley Research estimates

2009 2010 2011 2012

GDPBull

-2.63.0 3.8 4.8

Base 2.7 2.7 3.2Bear 2.4 1.6 1.6

CPI -0.31.8 2.4 2.91.6 1.8 2.21.5 1.3 1.5

Unemployment 9.39.6 8.4 7.69.7 9.2 8.39.8 10.0 9.0

Policy Rates (EOP) 0.125

0.50 1.50 3.500.125 0.125 2.500.125 0.125 1.00

1.5

2.0

2.5

3.0

3.5

4.0

1Q10A 2Q10A 3Q10E 4Q10E 1Q11E 2Q11E 3Q11E 4Q11E

MS Base Case (October 2010)MS "Full Sunset" Scenario (October 2010)

US Real GDP Growth (Quarterly % Change, SAAR)

Richard Berner, (212) 761-3398, [email protected]



16

Europe Economics Risk-Reward ViewInvestor Debates

Will Portugal/Ireland have to tap the EFSF? Will the crisis resolution mechanism replacing the EFSF in 2013 pave the way for a debt restructuring? –

When/how will the ECB move towards the exit? Is the ECB done buying peripheral government bonds? –

Could Germany see a consumer revival given its strong labour

market performance?


GDP growth of 1.6% this year, around 1.4% next year. Subdued inflation pressures (5Y/5Y fwds

at 2.14%).

ECB starting to gradually raise rates in H2 2011.

Ten-year bund yields to continue to move higher. Consensus forecasts are for 3% in late 2011.

Signposts

November 16 & 17 Eurogroup

Meeting Ecofin

Council Meeting UK MPC Minutes

November 23 & 24 France INSEE Mfg surveyGermany Ifo

index

Late November Troika to judge Greek progress

December 2 ECB Council Meeting & Press

ConfDecember 6

Eurogroup

Meeting

Budget IrelandEcofin

Council MeetingDecember 9

UK MPC Meeting

Elga Bartsch, (+44) 207 425 5434, [email protected]

Key Indicators Bull, Base, and Bear Cases – ECB Refi Rate

Base Case / Thesis 2011 GDP: 1.4%Our base case is for growth momentum in the second half of this year to return to the trend range of the strong print in 2Q. Incoming activity data point to upside risks to our official forecasts for growth to return to trend in 2H 2010. The stronger than expected momentum is a welcome cushion against the impact of a stronger euro. Several factors support our call for a slowdown between this and next year. First, there will be additional fiscal tightening at the beginning of next year, notably in the large countries. Second, even though credit growth seems to have troughed the recovery remains creditless. Third, outside Germany, the euro area recovery still remains largely jobless. With both growth and inflation being modest over the forecast horizon, we expect the ECB to be on hold until early 2012.

Bull Case 2011 GDP: 2.3%Bold policy action would address the issues in the banking system and force recapitalisation/restructuring. ECB keeps liquidity ample. Borrowing costs come down substantially, helped by credible fiscal consolidation. Global growth is even stronger led by EM and more expansionary policies globally.

Bear Case 2011 GDP: 0.5%Policy inaction and looming bank losses lead to full blown credit crunch. Inventory and investment recovery reverts. Fiscal austerity forced by the market lacks credibility and the periphery marks new wides. Global growth peters out as no one is stepping into the void left by the US consumer. A global inflation scare propels bond yields higher.

2009 2010 2011 2011–2015

GDPBull

-4.11.8 2.3 2.6

Base 1.5 1.4 1.8Bear 1.3 0.5 1.0

CPI 0.31.8 2.3 1.61.7 1.8 2.11.4 1.3 2.6

Unemployment Rate (%) 9.4

9.7 9.09.9 9.5

10.2 10.7

Policy Rates (EOP) 1.00

1.00 2.001.00 1.000.75 0.10

0

1

2

3

4

5

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

Refi rate

Base Case2.00

1.00

0.10




17

Japan Economics Risk-Reward ViewInvestor Debates

Will the yen weaken or strengthen?

Have JGB yields hit bottom?

Will politics change fiscal policy ?


Investors are reluctant to take short-horizon strong-yen positions in yen/dollar, fearing intervention. JGB investors are waiting to see the DPJ’s

stance on budget issues such as spending control, tax hikes, and civil service reform. Reduced BoJ

independence would likely be welcomed by markets, and bring earlier yen weakness.

SignpostsEarly NovemberBoJ

Law revision proposals discussed by a group in the ruling party and by opposition parties; pressure on BoJ

continues.End-NovemberProduction, inventory, employment indicators announced late in the month; these will determine whether BoJ

will be pushed toward increase of special fund.

December

Tax Debate Ruling party tax committee will debate corporate tax cut, elimination of special tax breaks, tax-loss carry-

forward extensions, etc.

Budget finalization Cabinet must approve draft budget for FY11 by end-December. Focal points: (a) whether new bond issuance will exceed the government’s declared Y44 trl

ceiling, (b) spending control, (c ) Revenue projections.

Robert Feldman, +81 3 5425-5385, [email protected]

Key Indicators Yen/US$: Breakout only in end-2011

Base Case / Thesis ¥93/US$ (end 2011)BoJ

remains behind the Fed in aggressiveness of easing stance, spurring continued yen strength. Although weak growth and continued deflation will spur more BoJ

easing, we expect BoJ

action to be slow and grudging, relative to other central banks. Only when deflation fears in US wane will we see reversal of yen strength

We still see strong demand from duration matching needs will keep demand for JGBs

strong. However, higher volatility has triggered “sell on strength”

in JGBs, and put a floor under yields at around 0.9% for the 10yr JGB.

Policy will drift as political disruptions continue. Credible direction will emerge only when politics settle, which could take several more months.

Bull Case ¥110/US$US growth surprises on the strong side, pushing Fed to a stronger rate hike, while DPJ government pressures BoJ

toward more easing. JGB yields rise as capital flows abroad; domestic investors show weaker home bias. Global growth strong enough to raise earnings sharply.

Bear Case ¥75/US$US growth double-dips, Fed does QE3, while BoJ

resists policy change. China slowdown hurts exports, harming earnings growth. Intervention by Japanese authorities might slow yen appreciation.


2010e 2011 2012 2013–2016

GDPBull 3.4 2.2 3.1 2.0Base 3.0 1.0 1.7 1.0Bear 2.7 -0.1 0.2 0.0

CPI

(Japan Core)

Bull -0.9 0.0 0.2 1.0Base -1.0 -0.3 -0.2 0.5Bear -1.1 -0.6 -0.5 0.0

Unemployment Rate

Bull 5.1 4.7 3.9 3.0Base 5.1 4.9 4.5 3.7Bear 5.1 5.5 5.9 5.0

Call Rate (EOP)Bull 0.05 0.25 0.50 1.5Base 0.05 0.05 0.25 0.5Bear 0.05 0.05 0.05 0.05

2 0 0 8 2 0 0 9 2 0 1 0 2 0 1 17 0

7 5

8 0

8 5

9 0

9 5

1 0 0

1 0 5

1 1 0

1 1 5

7 0

7 5

8 0

8 5

9 0

9 5

1 0 0

1 0 5

1 1 0

1 1 5Y e n / U S $ F o r c d a te2 9 O C T 1 0

2 s d b a n d , b a s e d o n1 0 0 d m - s d e v .



18

China Economics Risk-Reward ViewInvestor Debates

Whether headline CPI inflation is peaking or would keep rising through the year. In the latter case, the probability of another interest rate hike will be rising.

Whether property prices would correct before year end–

as supply comes on line–or resurge. In the latter case, the risk of another wave of austere measures would be high.


A Goldilocks Scenario.Signposts

December Early December, Central Economic Work Conference which will set the policy targets for 2011

Qing Wang, (852) 2848-5220, [email protected]

Key Indicators China: Economy Regained Momentum

Base Case / Thesis 2010 GDP: 10%2010 – Goldilocks On Track: We expect headline CPI inflation to peak at 3.7-3.8%YoY in Oct-Nov 2010 before declining below 3.5%YoY in Dec 2010. We forecast GDP growth at 9.3% YoY

(or 2.4% QoQ

SAAR) in 4Q10 and 10.2% for the year as whole. Our calls include: a) no additional rate hike through year-end; b) bank lending target is unlikely to be relaxed significantly beyond the original target of Rmb7.5tn; and c) RMB appreciation against the USD to continue, reaching 6.60 by end-2010.

Bull Case 2010 GDP: 11%If a) external demand were to be substantially stronger than envisaged under our baseline scenario; and b) a major slowdown in private residential property construction would not materialize while the social housing program would take off, a full-blown overheating would become possible.

Bear Case 2010 GDP: 9.0%The strong export growth in 1H10 may well turn out to be transitory, and the subsequent export growth over the course of the year would slow sharply. Austere policy measures against speculation in property market may weaken construction activity substantially, while the social housing program may fail to fill the slack in 2H10, resulting in a hard landing in FAI growth.


2009 2010 2011 2012–2016

GDP

Bull

9.6

11.0 11.0 9.5

Base 10.0 9.5 8.0

Bear 9.0 8.0 6.5

CPI

Bull

-0.6

3.3 4.5 4.0

Base 2.8 3.0 3.0

Bear 2.3 2.0 2.0

Trade Balance

(% of GDP)

Bull

4.0

3.3 3.5 3.0

Base 2.8 2.2 2.0

Bear 2.3 1.5 1.5

9.5

7 .5 7.1

15.1

12.7

9.8 9.2

8.3

10.0

2.8

11.1

0

4

8

12

16

20

Mar-08

May-08

Jul-08

Sep-08

Nov-08

Jan-09

Mar-09

May-09

Jul-09

Sep-09

Nov-09

Jan-10

Mar-10

May-10

Jul-10

Sep-10

GDP (QoQ, %, SAAR) Regained Momentum



19

AxJ Economics Risk-Reward ViewInvestor Debates/Themes

Will China’s current stabilization of domestic demand continue? Will policy makers signal softening in policy stance or continue with policy rate hikes?

Will increasing food and commodity prices, strong growth and delayed policy exit result in inflation risk in AXJ?

Will regions’

policy makers respond with stringent capital control measures on rising capital inflows?

What’s not in the price?

We expect China's policy rate hike to be one-off and expect policy makers to signal softening in policy stance in Q4-

2010, considering that the targeted moderation in demand appears to have been achieved.

We continue to see upside risk of inflation on strong growth, delayed policy exit and higher commodity prices.

If capital inflows were to become unmanageably high, some countries may initiate measures to discourage debt capital inflows, but not equity capital inflows.

Signposts

Nov 16BOK’s

monetary policy meeting

Nov 30India’s Quarterly GDP

Chetan Ahya, +65 6834 6738, [email protected]

Key Indicators CRB Commodity Index Above Pre-Crisis High

Base Case / Thesis 2011 GDP: 8.2%In 2011, we expect GDP growth to remain strong at 8.2%

(close to the trailing five-year average), compared with 8.9% in 2010 and 6.2% in 2009. We expect the region’s growth to be driven by domestic demand. We expect private consumption to continue to accelerate across the region. However, capex

growth is likely to moderate in China as well as AxJ

ex-China. Reflecting the relative strength of domestic demand, we expect the region’s net exports (as a percentage of GDP) to decline to 4.1% in 2011 from 4.3% in 2010 and the peak of 6.8% in 2007.

Bull Case 2011 GDP: 9.4%We believe the key driver that can influence our base case GDP growth forecasts positively would be an upside surprise in exports. Exports have already recovered above pre-crisis levels.

Bear Case 2011 GDP: 6.9%We think the key risk to our base case is any deterioration in EU’s sovereign debt concerns and/or US growth outlook, leading to a double-dip in the developed world. A double-dip in the developed world can pose downside risk to external demand and capital inflows.

2009A 2010E 2011e 2012e 2013–2017e

GDP

Bull

6.2 8.9

9.4 9.6 8.7

Base 8.2 8.0 7.6

Bear 6.9 6.4 5.8

CPI

Bull 4.8 4.6 4.3

Base 2.4 4.8 4.0 3.6 3.5

Bear 3.3 2.8 2.3

Policy Rates (EOP) 4.5 5.0 5.7 5.8

CAB (% of GDP) 5.3 3.4 2.9 2.8

Fiscal Balance (% of GDP) -3.7 -3.8 -3.2 -3.2

Source: Bloomberg, Morgan Stanley Research.

180

244

308

372

436

500

Sep

-02

Mar

-03

Sep

-03

Mar

-04

Sep

-04

Mar

-05

Sep

-05

Mar

-06

Sep

-06

Mar

-07

Sep

-07

Mar

-08

Sep

-08

Mar

-09

Sep

-09

Mar

-10

Sep

-10

10

33

56

79

102

125

148WTI US$ Per Barrel (RS)

CRB Food Index (LS)

CRB Commodity (LS)



20

Brazil / Latam Economics Risk-Reward ViewInvestor Debates

While authorities have tightened exchange controls, raising the IOF tax on fixed income, equity fund, multi market fund and debentures capital inflows, BRL keeps strengthening. Can the authorities fight the rally?

Mid-cycle moderation or more worrisome sign? We believe Brazilian growth is strongly linked to global cycle.


Brazil market is pricing in no more hikes this year and we agree, but we see another 175 bps of hikes in 2011 while the market sees 150 bps of tightening at most;

Equity and credit markets are once again showing significant strength and confidence that Brazil’s economy is likely to produce strong results this year and next.

SignpostsNovember 16Chile –

Monetary Policy Meeting

November 19Colombia –

Monetary Policy Meeting

October 26Mexico —Monetary Policy Meeting

December 1Chile –

Monetary Policy MinutesPeru –

CPI (November)

December 3Colombia –

Monetary Policy Minutes

December 5Colombia –

CPI (November)

December 8Brazil—Monetary Policy MeetingBrazil –

CPI (November)

December 7Chile –

CPI (November)

December 8Mexico –

CPI (November)

Gray Newman, (212) 761-6510, [email protected]

Key Indicators Brazil: Real GDP Growth(% change y-o-y)

Base Case / Thesis 2010 GDP: 7.9%Brazil’s economy is slowing. After posting GDP growth at 11.4% annualized pace in the first quarter, the economy stalled in April through July—the stalling was hard to see given the momentum at the beginning of the second quarter which kept the average for the second quarter up 5.1% on annualized basis over first quarter. Part of the slowdown may be a mid-cycle moderation, especially after tax breaks accelerated consumption in the first quarter. But we suspect slowdown may also have been a reaction at the time to a more cautious global outlook. The slowing allowed the central bank to slow the hiking pace in July and signal hikes may have ended for the time being in September.We suspect growth will be strong enough in 2011 to prompt the central bank to restart hikes under next administration.

Bull Case 2010 GDP: 8.7%Given lags between monetary tightening and the economy’s response, more fiscal stimulus for longer and supportive global backdrop, Brazil’s growth rate in the second half bounces back after mid-year to pace similar to what was seen in the first fourth months of the year.

Bear Case 2010 GDP: 7.2%The bear case assumes the economy stalls in the second half of 2010—even in that case, the strong statistical carryover in early 2010 should produce a solid headline average growth rate. It assumes that global conditions turn less supportive, while domestic concerns on political developments increase. Although we have growth moving back to 3% range in 2011, the headline annual GDP report would likely post closer to 2%.


2009 2010 2011 2011–2015

GDP

Bull -0.2 8.7 6.3 5.0

Base -0.2 7.9 4.0 4.0

Bear -0.2 7.2 2.0 3.0

CPI

Bull 4.3 6.2 6.0 5.5

Base 4.3 5.8 5.5 5.0

Bear 4.3 4.8 4.5 4.5

Policy Rates (EOP)

Bull 8.75 12.25 15.75 NA

Base 8.75 10.75 12.50 NA

Bear 8.75 10.75 8.75 NA

-4 .0 %

-2 .0 %

0 .0 %

2 .0 %

4 .0 %

6 .0 %

8 .0 %

1 0 .0 %

1 2 .0 %

J u n -0 4 M a r -0 5 D e c -0 5 S e p -0 6 J u n -0 7 M a r -0 8 D e c -0 8 S e p -0 9 J u n -1 0 M a r -1 1 D e c -1 1



21

India Economics Risk-Reward ViewInvestor Debates/ThemesNear term

Is market underestimating inflation and trade deficit risks in India?

Medium term

Infrastructure –

India’s long-term structural challenge now getting addressed, lifting sustainable growth rates.

Will India start outpacing China’s growth rates in 3-4 years’

time?

What’s not in the price?

We remain bullish on India’s structural as well cyclical growth outlook. However, we believe accommodative monetary and loose fiscal policies have pushed growth higher than the near-term potential. Over the next 6-12 months, we believe that monetary policy and fiscal policy exit will need to stay on course to manage the macro stability risks of a large trade deficit, rising inflation expectations and low deposit growth in the banking system.

SignpostsNovember 30 GDP data for QE-September

Next 6 Months Policy announcements on (1) divestment of the government’s stake in SOEs; (2) infrastructure sector including highways and electricity

Chetan Ahya, +65 6834 6738, [email protected]

Key Indicators BRIC: Two-year Trailing Average GDP Growth

Base Case / Thesis 2010 GDP: 8.5%Transitioning from policy-driven to private-sector- driven growth in 2010: We expect GDP growth to rise to 8.5% in 2010 compared to 6.7% in 2009. In 2010, even as policymakers gradually withdraw the monetary and fiscal policy support, we expect the growth momentum to be sustained.

Sustaining 8% plus growth in 2011: We expect the government to execute on several of the long-pending policy changes, ensuring acceleration in the capex

cycle

(manufacturing as well as infrastructure) along with steady growth in private consumption.

Bull Case 2010 GDP: 9.0%We see a bull-case scenario growth for India at 9% in 2010, assuming acceleration in pace of structural reforms from the government and better than expected external demand.

Bear Case 2010 GDP: 8.0%We think the key risk to our base case is a decline in global risk appetite and capital inflows in the country. Any spike in commodity prices will stoke inflation pressures and push current account deficit wider to vulnerable level.

E = Morgan Stanley Research estimates; Source: CEIC, IMF, Morgan

Stanley Research

2009 2010e 2011e 2012e 2013–17eBull 9.0 9.8 10.3 11.0Base 6.7 8.5 8.7 9.0 9.5Bear 8.0 7.7 7.8 7.5Bull 12.3 7.5 7.0 6.5Base 10.8 12.0 6.5 5.6 5.0Bear 10.5 5.8 5.0 4.0

Policy Rates (EOP) 4.75 6.25 7.50 7.75CAB (% of GDP) -2.2 -3.4 -2.3 -2.0Fiscal Balance(% of GDP)

GDP

CPI

-9.8 -8.1 -7.3 -6.9

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

E

2011

E

2012

E

Brazil RussiaIndia China



22

Russia Economics Risk-Reward ViewInvestor Debates

To what extent will the food prices and social transfers accelerate the CPI inflation in 2011?

When will the CBR start the rate hiking cycle?

What will the final privatisation plan and schedule look like?


Consensus sees GDP growth around

4.0% in 2010, and 4.5%

in 2011. We are slightly

more optimistic on this year but we see risks of the weakening external demand.

SignpostsNov-2010Final 2011-2013 Budget Law

Dec-2010The final privatisation plan from the government

Alina Slyusarchuk, (44) 20 7677-6869, [email protected]

Key Indicators Domestic Demand Takes Over as a Growth Engine

Base Case / Thesis 2010 GDP: 4.2%We expect growth to reach 4.2% in 2010. We cut our previous forecast of 5.5% due to lower than expected 1Q GDP growth as well as the slowdown in activity seen in the summer caused by extreme heat. We are positive on 2011 with our GDP forecast at 4.3%, thanks to a boost from investment. Also, the government plans to increase social spending prior to presidential elections in 2012. As a result, we are concerned about upside inflation risks next year, but are also optimistic on household consumption (+5.5%Y in 2011).

We expect the CBR to stay on hold until the end of the year, and to start tightening only in 2011, when the recovery is on firmer grounds.

Bull Case 2010 GDP: 5.0%Stronger commodity prices could boost short-term growth.

Bear Case 2010 GDP: 3.5%We see risks of the weakening external demand and more negative contribution from net exports. Hidden bad debt may constrain domestic demand and credit, while an absence of reform may leave growth stagnant.


2009 2010 2011 2011–2015

GDP

Bull

-7.9

5.0 6.5 6.0

Base 4.2 4.3 3.7

Bear 3.5 2.2 1.5

CPI

Bull

11.7

7.1 10.7 11.0

Base 6.7 9.0 8.1

Bear 6.4 6.8 4.0

Policy Rate

Bull

8.75

8.25 12.00 NA

Base 7.75 8.50 NA

Bear 6.75 6.00 NA

-40

-30

-20

-10

0

10

20

30

40

1Q-01

1Q-02

1Q-03

1Q-04

1Q-05

1Q-06

1Q-07

1Q-08

1Q-09

1Q-10

1Q-11

Real GDP HH consumption

Export Fixed investment

Import

% year on yearMS

forecast



23

US Rates Risk-Reward ViewInvestor Debates

What will be the size of QE2?

Will QE2 work, if no then what?

Will stimulus arise in the form of a streamlined refi

wave?

What will the impact of QE2 be on rate levels and the shape of the yield curve.


The Fed is priced to be out of the market until late 2011. Thus front-end rates a re priced to be low and stable. The market is also pricing QE2 to be ~$1Tr over the next year. UST 10yr could fall toward 2.25% as a result.

Trades•

We maintain our longs in front-end forward rates. This strategy that looks to take advantage of roll down and carry has been our core thematic trade. However, we are now looking at longer dated forwards as well,

•

We like owning the belly of the curve. In particular, we like owning UST 10y vs. 2s and 30s. We want to enter this position upon a back-up in yields. See chart.

•

In volatility space, we like owning variance swaps. Volatility is low but 10y rates are making many double digit daily moves; variance is a good way to play this. Political uncertainty and economic uncertainty are expected make rates volatile over the coming months.

Jim Caron, (212) 761-1905, [email protected]

Catalysts

Base Case / Thesis 10y Range: 2.25%-2.85%We are taking a more tactical approach to the market. We see the near-term range for UST 10y to be 2.25% -

2.85%.

The exposure in the market is that investors are long USTs. The record pace of inflows into bond funds confirms this. Real money is the main buyer as they were late to the bond market rally. For many, the Fed’s decision to buy USTs

was the game changer. Now with the details of the Fed’s QE purchases of $500bn USTs, we believe this may cause the 10y to drop to 2.25% and the UST 2s10s curve to flatten to 175bps.

A risk to ‘risk on’

trades is that low rates foster greater demand for higher returns and encourage investors to take on a larger duration exposure than they otherwise would.

Bull Case UST 10y 2.00%If economic data weakens materially and the Fed decides to launch a QE2 program whereby it purchases additional assets, then yields could materially drop.

Bear Case UST 10y 3.25%If the data surprises to the upside and removes the tail risk of

a faltering economy, thus the Fed may not engage in QE causing yields to rise materially. Note that investors are long

bonds and a liquidation/stop-out trade is a risk.

What we're watching Market Inflection Points

Flow of Money Bond funds continue to have a record pace of inflows despite the

fact that yields continue to fall. As long as the Fed engages in QE and keeps yields low, then there is little risk. But if rates start to rise, then the risk is an exodus from interest rate and spread products.

UST 10y Most investors believe that QE will take place at the Nov. 3 FOMC meeting. The expectation is for a sizeable program that drives yields lower toward 2.25%

Yield Curve The part of the curve that we expect to perform best is the 5-10yr belly. We believe QE purchases of USTs

will be biased toward this sector of the curve as it has the highest sensitivity to mortgage rates.


Gap

Re-Shaping the Curve maybe a Key Source of Alpha

Gap in T 2s10s Curve & 10s30s to Narrow



24

Europe Rates Risk-Reward ViewInvestor Debates

Peripherals: carry vs. potential event risk. Even those with a bearish “end game”

view are worried about the risk of underperformance.

If the EUR rallies on QE, what can the ECB do?


Rates: Decent sell-off in rates ahead of Fed QE announcement. Risk are two-way now but still with very little chance of ECB rate hikes priced for 2011-12

Peripheral CDS implies 5y cumulative probability of default for peripherals as follows (40% recovery): GR 52%, IE 35%, PT 31%, SP 19%, IT 16%.

TradesSpreads: Long IT SP FR & BE vs. short PT IE NL Long low coupon vs. high coupon in Greece, Ireland Portugal, Spain, (cheap insurance against contagion)

Rates: Duration: back to flat after 35bp sell-

off

Curve: 5s to underperform on the curve, 10s to outperform

Regulatory uncertainty adds volatility to 10/30: buy 5y 10/30 curve caps

Laurence Mutkin +44-207-677-4029, [email protected]

Peripherals still inside last month’s wides - just Catalysts

Base Case / Thesis Italy, Spain & France to perform into year-end

Three reasons to reverse underweight peripheral vs

core: 1.

Our tactical trading model has its smallest underweight to peripherals for 5 quarters

2.

Changes afoot in regulation of banks & insurance companies may support peripheral bonds

3.

For investors measured against a pan-Europe index, the balance of risks of owning peripherals, which was heavily skewed to the downside earlier in the year, is less heavily skewed now.

Positioning is, we believe, underweight Spain & France; and carry is positive for both vs

important indices. In the past month, spreads have moved in; but not by much.

Bull Case IT, SP tighten 30bp, FR by 10bpFor a/cs

benchmarked vs. broad EU indices, shorts in weighty peripherals (IT, SP) carry large underperformance risk, due to carry & contribution to index volatility. Same argument applies to France vs. AAA-only index.

Bear Case IT, SP widen 25bp, FR by 15bp Notwithstanding the bullish arguments, peripherals are subject to event risk & sharp swings in sentiment: something of that nature could easily overwhelm the carry cushion of these peripherals.

What we're watching Why it matters

EUR Trade-weighted EUR is +5% from summer levels. Another 7% would put it @ 2008-09 highs, raising possibility that ECB would have to be more accommodative

Peripherals Politics, budgets: with many weak or minority governments in the

EU, fiscal backsliding is a risk

NL pensions developments

A softening of ALM rules would see large steepening in 10/30 swap curve




25

UK Rates Risk-Reward ViewInvestor Debates

August Inflation Report was dove-ish, implying very low rates for very long. But with CPI, RPI well over target: how long can BoE (a) keep rates on hold; (b) maintain credibility? Sterling should be the first place to see erosion of credibility


Front end has rallied still further with 2s @ ~ funding +15bp: running out of upside here.

Gilts are trading tighter vs. Bunds despite the DBR flight-to-

quality, but have further to tighten

TradesLong Gilts vs. swaps in 30-yearsLong Gilts vs. Bunds moved in 10-

years & 5-yearsMaintain long 5s/20s steepener

Laurence Mutkin +44-207-677-4029, [email protected]

Gilts-Bunds can still narrow further Catalysts

Base Case / Thesis Weak growth plus fiscal tightening means Gilts should outperformGilts yields have fallen on election producing fiscally hawkish coalition government, but room to rally further.

Gilts/Bunds has narrowed but has further to run, as Gilts are still relatively too cheap & Bunds could cheapen further as flight-to-safety bid unwinds after bank stress tests.

We expect ongoing UK 30y ASW buying will support 30y Gilts.

Bull Case Gilts/Bunds narrows ~20bp to ~ +45bp

Spread has finally moved in, helped by growing confidence in the UK governing coalition’s sustainability & by Bunds unwinding some of their flight-to-quality bid after the EUR banks stress tests. The spread has further to go before reaching our target. Ongoing ASW buying from UK pension funds and/or cheapening of Bunds on EMU fiscal concerns spreading to core could sharply narrow Gilts/Bunds

Bear Case Gilts/Bunds widens to 100+bpFurther EMU flight-to-quality could see Gilts lag


Sterling A weakening in GBP would be a sign that the BoE may be unable to

“hold the line”

in its dove-ish

policy stance




26

EM Fixed Income Risk-Reward ViewInvestor Debates

Currency intervention –

how far will it go?

The impact of rising inflation expectations and commodities prices on EM fixed income.

Will the inflows to EM asset markets continue?


Macro and market dynamics have improved, assisting short-

term valuations for EM credit spreads and currencies relative to fair value. Prevailing EM sovereign credit spreads suggest market pricing EM real GDP growth of 5-7%, within the range of our economist forecasts.

TradesLong local-currency bonds: Israel, South Africa nominal bonds and Korea linkersReceive MXN 2y TIIE and 2y CLP/CamaraTRY 2s5s CCS steepenerZAR and PLN 2s10s flattenersLong TWD 1y5y swaption

payerPay INR 1-2y OIS on dipsLong MXN/ZARFavor

high-beta (Central and Eastern European countries, Ukraine, Dubai, Argentina) over low-beta creditsFocus on idiosyncratic risks: CIS banks and CIS/Latam

oil and gas (O&G) are attractiveGain exposure to EM growth through Argentina warrants and O&G sector

Catalysts

Base Case / Thesis +220 bpsOur macro metrics show incipient signs of stability for macro-

fundamental trends –

and likely moving from deteriorating to improving. This is the first time since 2Q this year; since that

time, EM risk markets have traded sideways to lower. This is an important development. It is likely to pave the way for more sustained EM asset price gains well into 2011. It increases the likelihood of our bull case scenario. EM inflation is likely to rise into 2Q11 and with it EM rates to rise and EM currencies to appreciate. Near-term, currency intervention is likely to intensify as response to the US implicit ‘weak dollar’

policy –

and as a result gains more limited, but EM currencies have scope to outperform 1H11 (vs

EUR and USD basket) on the back of sustained capital inflows, particularly into 2Q as inflation dynamics intensify.

Bull Case +180 bpsSustained capital inflows, signs of re-acceleration in EM growth and attractive long-term valuations argue for strong and steady gains for EM credit spreads (and currencies) through 1H11. For EM currencies, appreciation provides a means of tightening monetary conditions in the face of rising inflation.

Bear Case +380 bpsPeriphery Europe concerns may weigh on sentiment but we see no material prospect for contagion absent a seizing of DM funding markets. Signs of EM macro-fundamental improvement may prove to be fleeting, leaving markets with limited upside.


Capital flows Steady and strong flows into EM, so far mostly portfolio equity and fixed income likely to maintain upward pressure on EM asset prices and be met with policy response, which may lead to periods of volatility.

Currency policy Post-QE2 announcement and G20 the scope for intervention or capital controls. CNY trade-weighted revaluation likely to mitigate EM central banks weighing against strength in their currencies.

Monetary policy Inflation, likely to intensify in early 2011, ultimately requires a degree of policy tightening. Market may be uncomfortable with the prospect

of sustained tightening so early in the recovery.

EM rates – lower for now, but higher into 2Q11EM composite 2y IRS – Actual versus MS Model Prediction

Rashique Rahman, +44 207 677 7295, [email protected]: Morgan Stanley Research, Bloomberg

4.0

5.0

6.0

7.0

8.0

9.0

10.0

Jun-05 Mar-06 Dec-06 Sep-07 Jun-08 Mar-09 Dec-09 Sep-10 Jun-11Act Pred



27

FX Risk-Reward ViewInvestor Debates

How much QE is already in the price and thus how much will it continue to drive the USD lower.

ECB is normalising policy and ongoing rebalancing flows are likely to keep it the strong G3 currency for now.

Currency tensions remain a theme, despite G20. Modest capital controls continue to creep in pushing G10 higher.


Forwards discount 1.39 in EUR/USD and 80.3 in USD/JPY by year-end, respectively, compared with MS forecasts for 1.36 and 93.

TradesShort EUR/CHF target 1.28Long EUR/USD target 1.46Short EUR/SEK target 8.88Long GBP/JPY target 134.50Short MS Dollar Index target 65.00Long MS AxJ

Index target 120.00

Stephen Hull, (44) 20 7425-1330, [email protected]

EUR Rebalancing Demand Catalysts

Base Case / Thesis EUR/JPY +5% in 2010The Fed’s move to QE will continue to weigh on the USD, given the longer term implications for US inflation and the uncertainty of success. It is also clear that US policy makers view USD weakness as part of the solution. Until such time as EM takes on more appreciation, the axis of adjustment is likely to come via the EUR. This is particularly true whilst the ECB continues to see a passive normalisation of policy. We believe there is greater upside before Euro area policy makers will lean against this strength.The JPY should be weaker, from a fundamental point of view, although we may need to see more commitment to easing and an inflation target before this is reflected in the JPY.

Bull Case EUR/JPY +15% in 2010While the prospect of the Fed implementing more QE is being priced in, implementing this policy in a larger size and if it were open ended may result in greater demand for EUR. Meanwhile, the Japanese follow up their initial intervention with a credible easing policy and much larger, sustained intervention.

Bear Case EUR/JPY -10% in 2010The changes in the EU Treaty rules and concerns regarding the ability of the periphery to implement fiscal tightening weigh on the EUR. At the same time, the BoJ

does not provide credible additional easing. In addition, the biggest surprise would be a concerted effort by EM to allow for meaningful appreciation, this would ease the appreciation pressure on the G10 and EUR in particular.


The Federal Reserve The market has focused on the Fed’s QE but we are waiting for the specific details on the objectives as a guide for the extent of QE, as well as duration of the purchases. Post the meeting, we are monitoring for Fed member’s conviction regarding the effectiveness of the policy.

US Inflation Given the increased focus on inflation for the FOMC and the part

it is likely to play in driving QE, the inflation data is likely to be more important than usual. The surprise would be for greater than expected readings, strengthening USD.

Global Rhetoric on FX While the G20 meeting were committed to addressing imbalances and co-

operating in reducing tensions, we have seen more talk of capital controls post the forum. As such, with the USD expected to moderate, we are watching for any further action to counteract capital flows and EM appreciation.

Source: Morgan Stanley Research; EPFR, Bloomberg

- 6 0 0 0

- 4 0 0 0

- 2 0 0 0

0

2 0 0 0

4 0 0 0

6 0 0 0

8 0 0 0

J a n - 0 4 J a n - 0 5 J a n - 0 6 J a n - 0 7 J a n - 0 8 J a n - 0 9 J a n - 1 01

1 . 1

1 . 2

1 . 3

1 . 4

1 . 5

1 . 6

1 . 7

E M T o t a l F lo w ( m n U S D )

E U R U S D S p o t



28

DM Equities Risk-Reward ViewInvestor Debates

Strength and sustainability of macro expansion

Significance of policy action on macro cycle and risk assets/resolution of debt super-cycle

Extent of margin uplift/profits from EM expansion


Sell-side earning forecasts are for sustained earnings expansion: over 30% increase in EPS between 2010 and 2012 (both SPX and MSCI DM), after a sharp gain in 2010

Buy-side arguably more cautious. Equities appear cheap if consensus earning forecasts are correct

TradesRegional:Buy EM over DM

Sector:Long Europe ExportersLong US/Europe Industrials

Thematic:Buy Large Cap QualityBuy EM exposed DM stocksBuy Dividend Yield / Reliable Growth

Gerard Minack, (61) 2 9770-1529, [email protected]

Equity Returns Follow Cycle Lead Catalysts

Base Case / Thesis

DM: Equities range bound SPX 950-1250Three reasons to expect range-bound equities: 1) that’s what usually happens after big bear markets; 2) valuations point to low returns; 3) we expect a sub-par macro cycle.

So far markets have broadly followed the script. We don’t expect equities to break the range until either the structural problems fade (upside risk) or recession looms (downside). We think the latter is more likely, but not this year.

QE2 is the new unknown. While we doubt it will be a macro game-changer, it may help risk assets independently of the impact on macro. We think the risk-reward on equities is becoming less favourable, but QE2 may see more upside.

Bull Case Double-digit gains in 2011Sustained macro expansion, ongoing low rates, and further gains in margins and a QE2-inspired re-rating of risk assets. Earnings appear likely to meet consensus expectations for new record highs in 2011.

Bear Case Back to lowsSovereign stress takes hold in the G7 and/or double-dip as stimulus is withdrawn. DM markets would likely see a serious deflation scare in this scenario.


Leading indicators In a credit-less cycle, what moves equities is changes in earning expectations. Equities don’t worry about rates, they worry about growth. If growth sentiment worsens, equities will weaken.

Margins Margins have surprised us, and we think forecasts for 2011 are too high. If productivity slows, margin forecasts look too high.

Sovereign debt Sovereign stress is the sword of Damocles hanging over this expansion.

Source: IBES, DataStream

EXCESS EQUITY RETURNS AND OECD LEADING INDEX

-60

-45

-30

-15

0

15

30

45

60

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

EQ

UIT

Y-B

ON

D R

ET 6

M %

-20

-15

-10

-5

0

5

10

15

20

6M

SA

AR

%

GLO BA L* O EC D G7 LEI (RHS)

* EQUITY LESS BOND RETURN (6 MONTH) MSCI DM LESS ML G7 GOVT BOND INDICES



29

European Equities Risk-Reward ViewInvestor Debates

What is the outlook for growth in the global economy and European corporate profits in 2011?

What are the implications of further QE on growth, inflation and asset prices?

With regulations increasingly encouraging institutional investment in bonds who will buy equities in the future?


MSCI Europe trades on a consensus 12m forward PE of 10.8 compared to a long-run average of 14 and our subjective ‘fair value’

range of 11-12 for this cycle. Europe’s trailing dividend yield is 3.2%, the same as a pan-European government bond. Our CVI suggests an 85% chance of up markets in the next 6 months.

Graham Secker, + 44 20 7425-6188, [email protected]

Earnings Growth Leading Indicator (EGLI) Catalysts

Base Case / Thesis MSCI Europe: 1270We are overweight equities as we believe the market is too pessimistic on economic and corporate profit growth, while valuations are reasonable and broad longer-term sentiment is weak. We assume 4%+ global GDP growth in 2011 will translate into double-digit EPS growth again next year. Our base case index target offers 10% upside and hence does not imply any re-rating of European stocks. In our base case we also assume that the European authorities manage to stabilise

the outlook for eurozone

sovereign debt, with yields moving moderately higher due to a better growth environment.

Bull Case MSCI Europe: 1420‘Normal Cycle –

albeit with lower growth and lower rates’

(23% upside). Bond yields of 3.5%, short rates at 1.25%, CPI at 2.5% and 20% EPS growth in 2011. Using a CVI value of 0 (fair value) this implies a MSCI Europe target of 1420 and an implied 2011 PE of 13.1.

Bear Case MSCI Europe: 715‘Double-Dip’

(38% downside). Bond yields of 2%, 3M rates of 0.75% and headline CPI of 1.25%. EPS falls 20% in 2011. Using a CVI value of -2, this implies a MSCI Europe target of 715 and an implied 20011 PE of 9.8. In this scenario the European Shiller

PE would fall to 8.6.


Growth indicators Evidence that the economic recovery is sustainable should provide strong support for stocks. However weakness in lead indicators and job/wage data would raise fears in the market of a double-dip

Inflation and net flows into equities

Inflation expectations have risen in the US, UK and Europe over the last couple of months. Corroboration of this trend in the real economy will raise pressure on asset allocators to consider switching from nominal to real assets.

Corporate newsflow

re earnings and M&A

Corporate newsflow

has held up better than economic newsflow

over the last few months with companies’

maintaining confidence in their earnings outlook. With FCF yields at record highs and borrowing costs at record lows we expect to see an acceleration in M&A activity.

Source: MSCI, S&P, IFO, OECD, GSCI, Haver, Datastream, Morgan Stanley Research. For details

see

Upgrading European Earnings - Trough in 3Q09, 20% Growth in 2010, August 17, 2009.

-60

-40

-20

0

+20

+40

+60

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

Predicted YoY EPS Growth %Actual YoY EPS Growth %

Aug-11e YoY EPS = 44%

In-sample forecasts

Out-of-Sample forecasts

TradesOW equities, UW bondsSectors: O/W –

Insurance, Materials, Energy, TelecomsU/W –

Utilities, Cons Disc, Healthcare, Div Fins & Real EstateThemes: 1) Add some beta –

e.g. Financials & Commodities. 2) Superior EM growth –

Energy and Materials offer better value than Staples and Capital Goods.3) Reliable growth stocks should be long-term winners, however value stocks should outperform in the short-

term if the market rallies. 4) Dividend strategies –

we like high and secure dividend yielders; stocks where DY > credit yield; index dividend swaps.

http://linkback.morganstanley.com/web/sendlink/webapp/BMServlet?file=3e9cb1rl-3nkb-g000-bfb9-1920861553ac&user=8hk01almotv-254&__gda__=1345114130_b1217c5e50aaf95d141251574a38d1e8

http://linkback.morganstanley.com/web/sendlink/webapp/BMServlet?file=3e9cb1rl-3nkb-g000-bfb9-1920861553ac&user=8hk01almotv-254&__gda__=1345114130_b1217c5e50aaf95d141251574a38d1e8



30

Japan Equities Risk-Reward ViewInvestor Debates

Will the BoJ

ease? Or will Japan acquiesce in yen appreciation?

Domestic or export focus?

Is Japan just a trade, or can there be any longer-term story?


Potential double-dip in the US and global economies; widespread expectation of early, further material yen strength; suspicion BoJ

will be reluctant to ease further; EPS of 60 for Topix

TradesBuy domestic demand super-large caps: Large has underperformed small; super-large (Core 30) has underperformed large; within the Core 30 of Topix, domestic demand stocks have underperformed.

Sector model recommends : Banks, Non-Bank Financials; Telecoms, Marine Transport

Alex Kinmont, (81) 3 5424-5337, [email protected]

Topix Scenarios – Base Case = Back to 2004 Catalysts

Base Case / Thesis 2010 yr-end: Topix 1000The mid-cycle growth scare is passing out of the picture; meanwhile policymakers have begun to creep towards easier settings. We maintain our end-2010 target at 1000. Our bond-stock model continues to favour

bonds, suggesting choppy conditions until that changes, but that switch could occur quite soon if current trends are continued.The market trades at book value (2/3 of stocks below book); firms are profitable; earnings have been better than expected for H1 F10 and expectations revised up for H2 F10; earnings look as though they are now settling into roughly 20% annual growth. A 20% rally is possible.Yen weakness may prove elusive, but current strength is still the most likely trigger for further monetary loosening. We look for a stronger market and a stronger yen.

Bull Case 2010 yr-end: Topix 1100BoJ

eases more dramatically and further now that directional shift towards loosening has been achieved; Market gets to longer-run fair value quickly. Financials lead.

Bear Case 2010 yr-end: Topix 800BoJ

does nothing further; fiscal policy tightens as programs roll off; domestic recovery is interrupted and deflation resurgent. EPS rises but is a mild negative surprise vs. high expectations. Defensives lead as global investors “give up on Japan.”



BoJ Any unexpectedly aggressive additional change in stance will spark a sharp rally, or alternatively, a move away from easing could trigger a sharp correction.

Global leading indicators Signs emerging that we are close to another inflection point as the high frequency indicators begin to bottom out.

Inflation data Any indication of inflation, from whatever source, would be very

positive for equities.

1100

800829.51

1000

600

800

1000

1200

1400

1600

1800

2000

00 01 02 03 04 05 06 07 08 09 10



31

Asia / GEM Equities Risk-Reward ViewInvestor Debates

Can Asia / GEM transition towards sustained domestic demand lend growth offsetting a weak industrialised

world recovery and eurozone

sovereign issues?

Has monetary policy easing in China in 2009 weakened the banking system and generated an asset price bubble in property and more widely in fixed investment?


Consensus earnings growth expectations for EM have risen to 38% in 2010 from 30% at the start of the year. This is in-

line with our base case forecast made in November 2009. It is at 16% for 2011 currently. MSCI EM is trading at 13.9x on 12m forward PER metric, this leaves the asset class priced slightly above the 20-year average of 12.8x.

TradesWe reduced our equities OW to 4% from 6% (proxy MXEF) and raised our cash weighting, as well as reduced beta in out stock focus list. Reasons for this call: standard valuations metrics are in-line or slightly above long-run averages; technically overbought market; exceptionally strong fund inflows and concerning macro-economic indicator suggesting higher risk for double dip.

We are now overweight Asia and underweight Latin America, a region which tends to underperform during corrective phases of MSCI EM.

Our preferred markets are China, Russia, Korea, Malaysia and Czech Republic

Our sector overweights

are Consumer Discretionary, Financials and Energy. We are underweight Telecoms, Utilities and Healthcare

Jonathan Garner, +852 2848 7288, [email protected]

MSCI EM Trailing P/Book –Now 9% above Average Catalysts

Base Case (55%) MXEF: 1120 (+2%)The headwinds of monetary policy tightening in Asia and parts of Latin America are offset by a second year of global economic and earnings recovery. Global growth remains above 4.0% both this year and next. Commodity prices, firm somewhat from end 2009 levels over the year as a whole.

China engineers a successful soft landing in bank lending growth and property prices. There are no major political risk events impeding global trade and the RMB post de-peg revalues

steadily versus the US$ to 6.60 by year end. Earnings growth is 40% in USD whilst the year-end 2010 trailing PER ends at 16.0x, in line with the 20-year average.

Bull Case (30%) MXEF: 1650 (+50%)Economic growth is stronger and earnings growth is 50%. Funds flows reach the extreme levels of 2Q and 3Q07, prompting a valuation overshoot to trailing PER of 20.0x by year end (similar to end 2007). The payback would come in 2011.

Bear Case (15%) MXEF: 605 (-45%)An economic double-dip as eurozone

sovereign risk issues / other negative catalysts impact consumer and corporate confidence. Earnings recession begins again in late 2010. China fails to achieve a soft landing. Earnings growth is below 15% for the year as a whole with a year end trailing PER of 10.5x (average trough last three cycles).



Asian inflation Outside of India inflationary pressures are moderating. This is allowing forward PER to re-rate consistent with our base case as it did in 2H 2004.

Earnings Our base case of 40% EPS for MXEF would generate a 14% ROE and likely a tenth straight year of superior profitability to MXWO.

Funds Flow Dedicated EM equity funds reported positive inflows for 22 consecutive weeks, a record for 2010. EM funds reported cumulative inflows of $56bn for this period. Our bull scenario envisages a euphoric phase as in 2007 whilst to avoid the bear it is important that flows do not reverse on a sustained basis as they did in 2008.

2.1x

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

4.0x

Dec

-92

Dec

-93

Dec

-94

Dec

-95

Dec

-96

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

-07

Dec

-08

Dec

-09

+1 SD

-1 SD

L-T Avg

-2 SD

+2 SD



32

China (and Hong Kong) Equities Risk-Reward View

Jerry Lou, (852) 2848-6511, [email protected]

Valuation remains Attractive Catalysts


MSCI China FY1 PE

5

10

15

20

25

30

Oct-97 Oct-99 Oct-01 Oct-03 Oct-05 Oct-07 Oct-09

FY1 PE Average+0.5 std -0.5 std+1 std -1 std

Investor Debates

Has China entered into a rate hike and tightening cycle?

Will the property sector double dip and drag everything else down?

Will inflation hit China before it hits the developed markets?


Skeptical about growth sustainability as China has entered into a rate hike cycle.

Double dip of a policy induced property market.

Improved risk appetite thanks to QE2 demand contraction.

TradesOverweight high-beta sectors –

banks, properties, insurance, and materials.Underweight transportation, consumers, auto, and technology.

Base Case / ThesisWe remain bullish on China and Hong Kong equities.Despite the recent market recovery we remain bullish. We

think China is moderating growth to a more sustainable mode rather than hard landing after stimulus exit, with greater focus on domestic demand. Property price will turn weaker but volume should recover.

Policies will remain supportive amid quantitative easing globally and next rate hike unlikely in the next 6 months.Potential catalysts for market to rerate: 1)

the peaking out of CPI YoY

comp due to base effect shall ease inflation and tightening concerns; 2) consistent appreciation of the Rmb

against the US$ shall attract liquidity inflow to China assets including equities.

Bull CaseChina policies switch from tightening to loosening. New stimulus packages arrive as decelerating signs surface. China accelerates while global cost of capital remains low. Property transaction volume rebounds sharply.

Bear CaseRunaway inflation make regulators tighten aggressively, resulting in pessimistic growth prospects, and more severe asset quality problems in the banking sector.


Inflation risks QE2 has a danger to inflate energy and food price globally, which will force China to tighten prematurely. We are watching oil price closely to manage China tightening risk (oil leads China PPI).

Rmb

appreciation against the US$

With the de-peg from US$, if Rmb

consistently appreciates against the US$ in the coming few months, although slowly, it could attract additional liquidity into China equities.



33

Global Corporate Credit Risk-Reward ViewInvestor Debates

Corporates

and financials keep repairing balancing sheets, and liquidity is strong. But is this strong enough to offset unprecedented sovereign volatility?

Will the positives of bank deleveraging (less issuance, better capital) outweigh the negatives (credit contraction).

The “good spread / bad yield”

conundrum on corp. bonds.


IG credit spreads still imply a five-year default rate much worse than any seen since 1980, but HY spreads now no longer compensate for a “worse case”

experience (although one much worse than average). Implied credit volatility is at the low end of the YTD range, but the skew remains steep, indicating fears of large tail risks remain.

TradesBullish on credit globally, although US & Asia to Outperform Europe. Strong preference for High Yield over IG credit in the US.Long financials, and extend out the maturity curve. Tier 1 in Europe and Asia remains a core overweight, we believe Basel III is an important catalyst that will support bond calls.Positive basis means more value now lies in CDS. Sell bonds, sell protection, and take out dollar priceQuality High Yield remains cheap to Low-Quality IG in the US. Overweight BBs

vs. BBBs. Take default risk over spread risk. Shorten in non-financial IG credit. Long mezzanine risk in IG tranches and US CLOs. Short senior/super-

senior index tranches vs. DeltaTo hedge, we prefer buying payer spreads, rather than payers outright, given that the volatility skew in credit options remains highly elevated.


Credit still well off YTD Highs Catalysts

Base Case Keep Calm and Carry OnCredit valuations remain well supported in a lower growth, lower return world. Choppy economic data keeps the M&A cycle more conservative (and sensible) despite the cheap cost of debt capital. With our economists pushing back their rate hike expectations in both the US and eurozone, liquidity will remain ample for longer. Europe muddles through with weak domestic growth, with a weaker euro and pound helping to cushion the effects of greater fiscal austerity, and sovereign spreads stabilizing at higher levels. US and Asia credit outperform on a better growth and extended liquidity, led by Financials. Expect dispersion of performance by Region (Europe vs. Global), Instrument (cash vs. CDS), and regional revenue exposure.

Bull Case 2003-04 ReduxCentral banks stay on hold until mid-2011. Cash yields at 0% keep money pouring into the asset class, and the ECB is able to unlock coax European banks to deposit less there and instead by sovereign supply. Similar to 2003-04, companies remain adverse to increasing leverage.

Bear Case Global Double-DipIn Europe, the stress tests become a key missed opportunity to break the cycle of bank & sovereign fears, as weaker growth on the back of a strengthening EUR leads to their revival. In the US, low rates fail to motivate continued asset inflows, and continued disappointing data re-ignites double-

dip fears. For Asia, the “importing”

of loose monetary policy abroad leads to an over-heating

Source: Morgan Stanley Research, Bloomberg, iBoxx


Fund Flows Fixed income markets have seen record flows out of equities, and

into bonds, despite the lowest yields in generations. Are these inflows here to stay, or are they just chasing returns? Strong recent performance in Equity markets will also challenge retail investor perceptions

Issuance Patterns / Shareholder Friendly Activity

Our base case is that the unusually uncertain macro outlook has a silver lining: it is keeping corporates

much more conservative than they would otherwise be, given their all-in borrowing costs. Still, the longer this persists, the more comfortable companies may be with the new normal. Expect share buybacks, dividend increases, and LBO activity to pick up, although think 2003/04 (not 2006/07). If corporate thinking changes, we expect the US will lead Europe.

Levels: '10 Tights (LH), '10 Wides (RH), and Today

107

6.9%

450

96

$101

94

88

6.9%

382

65

$101

76

156

10.0%

630

140

$92

130US IG CDS (bp)

US HY CDS ($ Px)

Euro. IG CDS (bp)

Euro. HY CDS (bp)

€ Tier 1 (YTC, %)

Asia IG CDS (bp)



34

Securitized Credit Risk-Reward ViewInvestor Debates

Magnitude and timing of losses in mortgage pools, both residential and commercial.

The scope and effectiveness of foreclosure mitigation.

Re-emergence of new issuance beyond consumer ABS.


Severe outcomes for collateral performance, much harsher than how the collateral is currently performing and expected to perform going forward. For example, in typical subprime RMBS, market pricing generally assumes that 80-90% of currently performing loans will eventually default and there will be no improvement in currently delinquent loans.

TradesLong senior tranches of non-agency RMBS (subprime and alt-A)Credit steepeners

in CMBS –

(long AAA, AM and AJ tranches versus short AA and below tranches)Long AAA and AA tranches of US and European CLOs

Long A and BBB tranches of US CLOs

Vishwanath Tirupattur, (212) 761-1043, [email protected]

Shadow Inventory in US Housing Catalysts

Base Case / ThesisIn non-agency RMBS, market pricing solves for mid to high single-digit returns assuming draconian outcomes for collateral performance. This provides a substantial positive convexity potential if the realized collateral performance turns out to be even slightly better than what is priced in.

In CMBS, we expect collateral deterioration to continue but the uncertainty about future losses to subside such that the at the money point in losses would be around AA tranches, which leaves the AAA stack to be significantly underpriced.

In CLOs, the allocation of risk premium to senior tranches is inconsistent with other risk remote tranches and the underlying loans. The at-the-money tranche has moved down to BBB or below.

Bull CaseForeclosure mitigation efforts succeed in reducing the shadow inventory and strategic default incentives, leading to significant improvement in RMBS collateral performance. Similarly, losses in CMBS pools turn out to be lower along with uncertainty about remaining duration. In CLOs, the AAA mispricing corrects (tightening of 100 bps) and leveraged loan defaults remain in the 4-6% range.

Bear CaseForeclosure mitigation efforts do not succeed in reducing the shadow inventory and strategic default incentives, leading to extension of durations on non-agency RMBS. In CMBS as well, loan modifications lead to extension of duration beyond 3 years. Leveraged loan defaults spike to >12%.



Progress on HAMP, HAFA and 2MP

The implementation and success of foreclosure mitigation has significant impacts on the timing and amount of cash flows to investors

Put Back Potential Put backs are not currently being priced in, creating a free option in senior RMBS tranches. The question is whether investors can gather the requisite interest to clear the hurdles in the path of put backs.

Special Servicer Activity in CRE Pools

Refinancing and modifications of maturing loans are a crucial determinant of the magnitude and timing of CRE losses

0

2

4

6

8

10

12

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Total Inventory

Yearly Home Sales

Milli

ons

of U

nits



35

Crude Oil Risk-Reward ViewInvestor Debates

Non-OECD remains strong, but YoY

comps will be tougher in Q4. OECD demand though has started to improve, and together with robust non-

OECD demand, global demand sits just shy of record highs (~1.3 mmb/d). Inventories, though drawing, remain lofty, but only because supply has surprised to the upside. Nonetheless, the ability to grow upstream production on a go-forward basis remains the biggest challenge facing the energy market. As demand improves, spare capacity will fall, forcing prices higher to ration demand.


Crude oil prices have broken through the range-bound ($70-$80/bbl) market we’ve seen for the most of the last year, continuing to trade at the whim of the macro though improved fundamentals have also lent support. Prices will, in our view, ultimately trade higher into year-end as refiners exit maintenance, bolstering crude demand and tightening both inventories and spreads. Deferred prices are not reflecting the supply side reality and will need to increase markedly from current levels, in our view.

Trades Long deferred crude oil. WTI for delivery in December 2011 is trading near $87/bbl. If our estimates prove correct, prices will need to move markedly higher from current levels (targeting $100/bbl average price for 2011) to ration demand.

Last month, we highlighted that WTI spreads would likely come under pressure as refiners went down for maintenance. Spreads actually tightened, which suggests a tighter-than-expected near-term S/D. Spreads should tighten further in the coming weeks as some 4-5 mmb/d

is coming back online.

Hussein Allidina, (212) 761-4150, [email protected]

Inventories Set to Draw Materially in 2011 Catalysts

Base Case / Thesis YE 2010= $95/bblThe biggest driver of crude pricing has been and continues to be

the market’s appetite for risk. QE2 and inflation expectations will provide support for crude in the coming months, however, improving fundamentals are now becoming a focus. Demand is vibrant. Chinese industrial activity also points to higher demand comps as the latest PMI reading for October registered at 54.7.

Moving into 2011 and 2012, the market’s focus will again revert to the constraints facing supply. With most of the low-hanging fruit on the demand side already picked, we anticipate that prices will need to move markedly higher to ration demand and find equilibrium. Specifically, we spare capacity falling to 4.1mmb/d and 2.5 mmb/d

respectively at year-end 2011 and 2012 as OPEC increases production to compensated for rapidly falling inventories. Our 2011/12 price forecast of $100/bbl and $105/bbl, respectively, represents an oil burden of 4% –

a level, historically, at which oil demand and economic growth have started to sputter.

Source: IEA, Morgan Stanley Research estimates


US/Euroil/China Fundamentals Data

Provides relatively timely confirmation of demand developments in the OECD –

weekly for the US, monthly for Europe –

as well as for China, the biggest delta on the margin –

monthly data for China.

Physical Markets The structure of the forward curve, as well as prices of crude and products in the cash markets, provides color on what the fundamentals are saying –

little influence in these markets by specs.

Economic data Positive data would continue to bolster equity markets, as well as providing confidence in demand.

2.40

2.45

2.50

2.55

2.60

2.65

2.70

2.75

2.80

2.85

2005 2006 2007 2008 2009 2010 2011 2012(1,250)

(750)

(250)

250

750

1,250

OPEC Crude Prod MoM Δ - RHS OPEC Adds/CutsStocks - LHS (bln bbls) MS Forecast - LHS (bln bbls)Inv. Path without OPEC Invervention

Bull Case YE 2010: $110/bblBetter-than-expected demand, which would likely lift risk appetite, and/or supply disruptions, would force balances and spare capacity to tighten faster than we’ve modeled in our base case (1.7 mmb/d

global demand growth).

Bear Case YE 2010: $60/bblIf we are wrong, and the economy falters materially (read: risk off), oil demand growth is likely to disappoint, leaving spare capacity and inventories more ample than we forecast in our base case. However, lower prices should ultimately serve to help demand growth while discouraging OPEC production. Net, any weakness is likely to be short-lived.



36

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10

Premium

EM 3m Avg Imp Vol

DM Avg 3m Imp Vol

Global Equity Derivatives Risk-Reward ViewInvestor Debates

The likelihood of a double-dip, with impacts on the level of volatility overall, as well as skew and term structure

EM vs. DM risk profiles

Monetizing steep volatility term structures

When will the macro fade and inter and intra-market correlation decline


A secular shift in risk from EM to DM, with emerging market implied volatilities now trading below those of developed markets, and with flatter skew

Continued high correlation between single-stocks, and persistent volatility for years into the future, largely reflective of risk aversion

US TradesProtection:

Buy 3m S&P 500 OTM put spreads. Buy S&P 500 puts knocking in on higher gold.Upside:

Buy 3m S&P 500 OTM callsYield:

Sell 2y S&P 500 variance, buy 2012/13 S&P dividends, and buy-write select single names

European TradesProtection: Buy 3m SX5E OTM put spreadsUpside:

Buy 2012/13 SX5E dividendsYield:

Sell Dec10 puts on select high and secure dividend stocks

Asia and EM TradesProtection: Buy 3m KOSPI OTM puts; buy 3m IBOV OTM put spreads; buy OTM puts on Indian, Australian banks; and sell OTM puts on China, HK banks; buy PSC’s

over select Aussie stocksUpside: Buy OTM calls or worst-of-calls on basket of EM-driven indexes Volatility:

Buy/sell 3m EM/DM straddles and put or call combos

Sivan Mahadevan, (212) 761-1349, [email protected]

EM vol trading similar to DM Catalysts

Base Case / ThesisWe believe a sustainable, if bumpy, global recovery will push volatility below current levels that are moderately stressed. We expect DM volatility to normalize more than EM given the excess risks priced in. Given risk factors disproportionately impact DM markets, DM skew and term structure will likely remain steep. We believe intra-market correlation will fall, although sustained differentiation will take time to materialize.

We wouldn’t buy volatility here, but we like entering into directional option trades while saving some budget for cheaper levels. We would lean against skew to buy protection, with upside exposure worth buying as well.

Bull Case VIX in the low teensA straight line recovery strong enough to grow out of financial and sovereign problems, with moderate inflation, would drive volatility towards, but not all the way to, cyclical

lows.

Bear Case VIX in the low 40sA double dip in developed markets, driven by a weak recovery, over tightening in China, or European sovereign stress impacting fundamentals could drive volatility to cyclical highs (excluding the depths of the financial crisis). Contagion to core DM sovereigns would drive a more extreme volatility tail.

Source: Morgan Stanley Research, MS Quantitative & Derivative Strategies


Steepness of volatility curves

Due to uncertainty over growth, deflation, and the impact of government stimulus and interest rate policy, uncertainty is high both near and longer-term.

Growth metrics in US, China, and Europe

A double dip is the fundamental risk that is keeping volatility high; improving data could be a catalyst for normalization.

High correlation between asset classes has fallen

Cross-asset correlations have declined across the board, although they remain high historically.

In the United States, portions of this report regarding non-US options are intended for Morgan Stanley’s Institutional Clients only.



37

Global Credit Derivatives Risk-Reward ViewInvestor Debates

The likelihood of a double-dip, with impacts on the level of volatility overall, as well as skew and term structure

M&A activity and the impact on junior tranches

How to isolate credit risk from rates risk

How to position for year-end


Correlation has fallen in IG tranches, indicating that the market is pricing in more idiosyncratic risk today

In HY tranches, equity tranches are cheap, ignoring positive fundamentals in the short dated maturity

Credit volatility is still rich, pricing in an expectation that credit will continue to be volatile

Trade IdeasTRANCHES:Long 5-year IG15 3-7% and 7-15% risk: Based on both relative and absolute value measures, and expectations for flows into junior mezzanine in this part of the cycle. Long HY15 0-15% vs short 15-25% on a relative basis: We like delta hedging an equity long with a mezzanine short in the new HY15 tranches.Short 5-year 15-100% risk: A good large-tail scenario hedge.OPTIONS:Buy put spread collars to hedge spread widening on an overweight portfolio.Buy payer ladders to hedge spread widening on underweight positions.Buy receiver ladders to hedge a spread tightening on an overweight portfolio.Buy receivers or receiver spread collars to hedge spread tightening on an underweight portfolio.


Catalysts

Base Case / ThesisThe strong rally in credit has taken us back to pre-sovereign crisis ranges, though we are still not back at the spread tights for the year. Much of this rally has been driven by favorable global central bank policies as well as an improving macro environment and growth story. However, credit options markets have not fully reset to pre-crisis levels and implied volatility remains elevated. Skew remains steep, particularly in relation to equity skew. Given this, we are inclined to use volatility neutral or even short strategies in this market.

In the face of continued healing we also expect implied default correlation to flatline

in IG.

Bull Case Correlation and volatility dropContinued market recovery that causes idiosyncratic risk to rise and default correlation to flatline

and volatility to continue to decline.

Bear Case Correlation and volatility riseA double dip in developed markets, driven by a weak recovery, over tightening in China, or European sovereign stress impacting fundamentals could drive volatility to cyclical highs (excluding the depths of the financial crisis). Contagion to core DM sovereigns would drive a more extreme volatility tail.



Growth metrics A double dip is the fundamental risk that is keeping volatility high; improving data could be a catalyst for normalization.

Mezzanine tranche performance

As markets continue to heal, risk will shift out of the mezzanine tranche and into other parts of the capital structure

Volatility levels Peripheral European stress coupled with US growth uncertainty could cause volatility to remain elevated

In the United States, portions of this report regarding non-US options are intended for Morgan Stanley’s Institutional Clients only.

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

120%

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

CDX IG

3M Implied Vol

5yr implied correlation

Credit vol trending lower



38

Cross-Asset Volatility

Note: Rate volatility is in normalized basis points, credit volatility is volatility of spreads, and all others are price return

volatility * Pre-Crisis Average is the average level from 7/1/06 through 6/30/07

Source: Morgan Stanley Research, Morgan Stanley Quantitative and

Derivative Strategies, Bloomberg

Asset Class Asset Current Vol2006-2007 Average

Change in 3m Imp since late-May

Peak12m

Percentile

Change in Skew since late-May

Peak12m

Percentile

Change in Spot Level since late-May

PeakCredit CDX IG 58% NA -30% 22% -1% 66% -17 bps

iTraxx 69% NA -25% 38% 0% 70% -15 bpsEquities KOSPI 18% 18% -8% 20% -4% 51% 17%

IBOV 23% 35% -13% 5% -1% 64% 21%SPX 22% 13% -12% 48% -3% 62% 7%SX5E 25% 15% -13% 63% -5% 59% 6%

Commodities Oil 31% 29% -9% 12% -1% 51% 10%Gold 18% 19% -6% 26% 0% 64% 10%

Rates 1y US Swap Rates 40 bps 61 bps -23 bps 0% 20 bps 63% -38 bps10y US Swap Rates 106 bps 67 bps -14 bps 41% 3 bps 25% -72 bps

FX EURUSD 12% 7% -4% 70% 2% 92% 10%

Volatility Heals Substantially, Tail Risks Still Somewhat Elevated

Markets have normalized somewhat

Since the 2010 peaks in volatility (in mid-May) markets have resolved some of the global macro-economic risks. European governments have policies in place to relieve banking and sovereign related stresses. However fears of a potential global economic slowdown remain prescient in investors’

minds.

Volatility has fallen dramatically Among asset classes we consider, volatility has fallen across the board. We see the greatest drops in US and European credit and equities, as volatility here was the highest in May, and near-term fears have been pushed out further in the term structure.

Entry points much more attractive today

The fall in volatility with still moderate levels of skew in many markets makes the overall entry point for short-dated hedges attractive today compared to most of the 2nd and 3rd quarters of

2010. Long-dated hedges remain expensive in many markets.

How to hedge today We take advantage of lower levels of volatility, still steep skew and some relative value to identify hedging strategies across the asset classes cover in this report. Our preferred strategies range from simple OTM puts, to put spreads, strangles and cross-asset “knock-in”

hedges where high levels of correlation can reduce costs.

Portions of this report regarding non-US options are not intended for US clients, other than Institutional Clients. Investing in options is not suitable for all investors. Please see the disclosures at the end of this report and discuss whether this or any particular options strategy is suitable with your Morgan Stanley representative. Please direct all market-specific questions to the coverage analyst and all options-specific questions to Sivan Mahadevan, Derivative Research Strategist.




39

Calls: The maximum potential loss is the premium paid.

Call Spreads: The maximum potential loss is the premium paid.

Overwriting (selling calls over long stock positions): At expiry the risk is that the stock rallies through the short call strike, with the stock called away at the strike price, limiting participation in

further upside.

Puts: Overlaid on a long stock position, the position is protected below the strike at expiration. The maximum potential loss in isolation is the premium paid.

Put Spreads: Overlaid on a long stock position, the position is protected between the strikes (but not below) at expiration. The maximum potential loss in isolation is the premium paid.

Underwriting (selling puts): The max loss is the strike less the premium. Above the strike investors keep the yield, but must be

willing to miss out on any near-term upside as well.

Put Spread Collars: Overlaid on a long stock position, the position is protected between the strikes at expiration. If the stock rallies through the short call strike, investors could be forced to sell

their stock and upside will capped. The maximum loss on the option position alone is unlimited due to the short call.

Call Spread Collars (Call Spread + Short Put): Overlaid on a short stock position, the position is protected between the strikes (but not above) at expiration, while profit is capped below the strike of

the put sold. The maximum potential loss in isolation is the level of the put strike plus/minus the initial premium.

Straddles and Strangles: The maximum potential loss on a long straddle or strangle is the premium paid. The maximum potential

loss on a short straddle or strangle is unlimited.

Dividend Futures/Swaps: Investors long dividend futures/swaps participate 1:1 in movements on the underlying dividend levels. If the dividend index rises the position will show a profit and a loss if the index falls below the entry price.

Variance/Volatility Swaps: At expiry, an investor long/short a variance/volatility swap will be paid the difference between the

volatility (squared for variance) and the strike price (or vice-versa for short variance positions) that is realized over the term of the contract. If realized volatility is above the strike price, there will be a gain/loss, and if realized volatility is below the strike price, there will be a loss/gain. Prior to expiry, spot starting variance swaps have exposure to both implied and realized volatility, with the realized volatility exposure progressively accruing and the implied volatility exposure decaying.

Option Strategy Risk Factors



40

Options are not for everyone. Before engaging in the purchasing or writing of options, investors should understand the nature and extent of their rights and obligations and be aware of the risks involved, including the risks pertaining to the business and financial condition of the issuer and the underlying stock. A secondary market may not exist for these securities. For customers of Morgan Stanley & Co. Incorporated who are purchasing or writing exchange-traded options, your attention is called to the publication “Characteristics and Risks of Standardized Options;”

in particular, the statement entitled “Risks of Option Writers.”

That publication, which you should have read and understood prior to investing in options, can be viewed on the Web at the following address: http://www.optionsclearing.com/about/publications/character-risks.jsp.

Spreading may also entail substantial commissions, because it involves at least twice the number of contracts as a long or short position and because spreads are almost invariably closed out

prior to expiration. Potential investors should be advised that the tax treatment applicable to spread transactions should be carefully reviewed prior to entering into any transaction. Also, it should be pointed out that while the investor who engages in spread transactions may be reducing risk, he is also reducing his profit potential. The risk/ reward ratio, hence, is

an important consideration.

The risk of exercise in a spread position is the same as that in

a short position. Certain investors may be able to anticipate exercise and execute a "rollover" transaction. However, should exercise occur, it would clearly mark the end of the spread position and thereby change the risk/reward ratio. Due to early assignments of the short side of the spread, what appears to be a limited risk spread may have more risk than initially perceived. An investor with a spread position in index options that is assigned an exercise is at risk for any adverse movement in the current level between the time the settlement value is determined on the date when the exercise notice is filed with OCC and

the time when such investor sells or exercises the long leg of the spread. Other multiple-option strategies involving cash settled options, including combinations and straddles, present similar risk.

Important Information:•

Examples within are indicative only, please call your local Morgan Stanley Sales representative for current levels.•

By selling an option, the seller receives a premium from the option purchaser, and the purchase receives the right to exercise the option at the strike price. If the option purchaser elects to exercise the option, the option seller is obligated to deliver/purchase the underlying shares to/from the option buyer at the strike price. If the option seller does not own the underlying security while maintaining the short

option position (naked), the option seller is exposed to unlimited market risk.•

Spreading may entail substantial commissions, because it involves at least twice the number of contracts as a long or short position and because spreads are almost invariably closed out prior to expiration. Potential investors should carefully review tax treatment applicable to spread transactions prior to entering into any transactions.

•

Multi-legged strategies are only effective if all components of a suggested trade are implemented.•

Investors in long option strategies are at risk of losing all of

their option premiums. Investors in short option strategies are at risk of unlimited losses.•

There are special risks associated with uncovered option writing

which expose the investor to potentially significant loss. Therefore, this type of strategy may not be suitable for all customers approved for options transactions. The potential loss of uncovered call writing is unlimited. The writer of an uncovered call is in an extremely risky position, and may incur large losses if the value of the underlying instrument

increases above the exercise price. •

As with writing uncovered calls, the risk of writing uncovered put options is substantial. The writer of an uncovered put option bears a risk of loss if the value of the underlying instrument declines below the exercise price. Such loss could be substantial if there is a significant decline in the value of the underlying instrument.

•

Uncovered option writing is thus suitable only for the knowledgeable investor who understands the risks, has the financial capacity and willingness to incur potentially substantial losses, and has sufficient liquid assets to meet applicable margin requirements. In this regard, if the value of the underlying instrument moves against an uncovered writer’s options position, the investor’s broker may request significant additional margin payments. If

an investor does not make such margin payments, the broker may liquidate stock or options positions in the investor’s account, with little or no prior notice in accordance with the

investor’s margin agreement. •

For combination writing, where the investor writes both a put and a call on the same underlying instrument, the potential risk is unlimited. •

If a secondary market in options were to become unavailable, investors could not engage in closing transactions, and an option writer would remain obligated until expiration or assignment.

•

The writer of an American-style option is subject to being assigned an exercise at any time after he has written the option until the option expires. By contrast, the writer of a European-style option is subject to exercise assignment only during the exercise period.

Options Disclosure

http://www.optionsclearing.com/about/publications/character-risks.jsp



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Disclosure SectionThe information and opinions in Morgan Stanley Research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or RMB Morgan Stanley

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Peters, Jason Draho, Alina

Slyusarchuk, Jim Caron, Laurence Mutkin, Rashique

Rahman, Gerard Minack, Graham Secker, Alex Kinmont, Jonathan Garner, Jerry Lou, Vishwanath

Tirupattur, Sivan Mahadevan.

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Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions.



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Disclosure Section (Cont.)STOCK RATINGS Morgan Stanley uses a relative rating system using terms such as

Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations.

Global Stock Ratings Distribution (as of October 31, 2010)

For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and

Sell alongside our ratings of Overweight, Equal-

weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of

Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively.

Coverage Universe

Investment Banking Clients (IBC)

Stock Rating Category

Count

% of Total

Count

% of Total IBC

% of Rating Category

Overweight/Buy

1122

40%

413

44%

37%

Equal-weight/Hold

1158

41%

411

43%

35%

Not-Rated/Hold

121

4%

22

2%

18%

Underweight/Sell

393

14%

103

11%

26%

Total

2,794

949

Data include common stock and ADRs

currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months.

Analyst Stock Ratings

Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total

return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.



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Disclosure Section (Cont.)Analyst Industry Views Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below.

In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below.

Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below.

Benchmarks for each region are as follows: North America -

S&P 500; Latin America -

relevant MSCI country index or MSCI Latin America Index; Europe

-

MSCI Europe; Japan -

TOPIX; Asia -

relevant MSCI country index.

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Investment Research & Analysis (CIRA) research reports may be available about the companies or topics that are the subject of Morgan Stanley Research. Ask your Financial Advisor or use Research Center to view any available CIRA research reports in addition to Morgan Stanley research reports.

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Morgan Stanley produces an equity research product called a "Tactical Idea." Views contained in a "Tactical Idea" on a particular stock may be contrary to the recommendations or views expressed in research on the same stock. This may be the result of differing time horizons, methodologies, market events, or other factors. For all research available on a particular stock, please contact your sales representative or go to Client Link at

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markets transactions performed by Morgan Stanley or the profitability or revenues of particular trading desks.



44

Disclosure Section (Cont.)Morgan Stanley Research is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or

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45

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11-16-10 po

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2010 Morgan Stanley



46©2010 Morgan Stanley

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November 16, 2010 global debates playbook shifting to neutral on more balanced risks 1

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