Is Sell in May Still in Play?

Transcription

GLOBAL INVESTMENT COMMITTEE / COMMENTARY
JUNE 2013
On the Markets
MICHAEL WILSON
Chief Investment Officer
Morgan Stanley Wealth Management
Is Sell in May Still in Play?
In each of the past three years, May has been a cruel month
for investors, with the annual summer swoon starting at the
beginning of the month and finishing one to four months
later. This year, there was much speculation about the pattern
repeating itself, but the consensus was surprised as safehaven assets sold off instead. In fact, global bonds had their
worst month since 2004, when the Federal Reserve began to
tighten after a period of extended easy monetary policy.
TABLE OF CONTENTS
2
Reversal of Fortune
For the global economy, 2013 looks like the
reverse of 2009.
The Tech Sector: Where the Cash Is
4
Technology companies now hold about onethird of all balance-sheet cash.
Whither US Equity Markets?
6
Over the long term, US stocks have
delivered 6% average annual real returns.
The US Manufacturing Play—in Mexico
8
Mexico has strong links to the US industrial
sector and improved competitive standing.
Bonds Swoon Over Jobs Data
10
Better news on the payroll front triggered a
significant backup in yields.
Downside Risk Beats Upside Potential
12
High yield bonds have defied expectations,
leading to an unfavorable risk/reward ratio.
Alternatives Abound in Mutual Funds
13
More mutual funds are starting to invest like
hedge funds.
Follow us on Twitter @ MSWM_GIC This time, the bond sell-off began as investors realized the global economic recovery
might finally be reaching “escape velocity.” The selling accelerated with talk of the Fed
starting to scale back asset purchases as soon as this summer.
Risky assets like stocks initially reacted positively to this increased growth expectation,
but then sold off in the second half of May as good economic news was interpreted as
potentially negative for valuations should the Fed decide to remove some stimulus.
The leading indicator for this market unrest has been bond volatility, which bottomed
May 8 and is showing no signs of stabilization. Bond volatility is critical to markets
because interest rates are the chief pricing mechanism for other assets, which poses the
question: If rates aren’t stable, how can investors be comfortable with the prices of stocks,
real estate, commodities or other risky assets? In other words, we believe bond volatility
will need to settle down before risky assets are able to resume their upward trajectory. We
think it will do so, but expect it to take some more time.
In this month’s On the Markets, we discuss how and why different regions around the
world have diverged so meaningfully from each other since the financial crisis and why
that is likely to continue. We also put the bond market sell-off into context and highlight
why high yield credit appears to offer more downside risk than upside potential. Finally,
with all asset prices inflated by aggressive central-bank activity, there is reason to believe
this summer could see higher volatility if concerns about the Fed tapering come to fruition.
In this environment, alternatives that provide more downside support and pure alpha
opportunities make sense to us. The good news is that all investors can now access this
important asset category via alternative mutual funds, for which Matt Rizzo of our
Investment Adivsor Research group provides a thorough summary of how they work and
what they can offer one’s portfolio.
ON THE MARKETS /ECONOMICS
Why ’09 Turned Upside
Reads ‘13
Institutional Flexibility Has Created
Corporate Resilience
22%
After-Tax Corporate
Profits as a Percentage of
Corporate GDP
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our years ago, the US was the
epicenter of risk, threatening to pull
the global economy into a second Great
Depression. Europe was exposed to the
fortunes of the US economy; Japan was
largely irrelevant, with a global recession
doing little to change either its growth or
deflation dynamics; and, despite shock to
world trade, emerging market (EM)
economies were the bastions of growth,
thanks to their hard-earned macro stability,
well-functioning transmission mechanisms
and aggressive policy action.
Now, the US economy appears to have
the best prospects for returning to trend
growth among the larger developed
markets and even most EM economies.
The dubious distinction of being the global
epicenter of risk has long been passed to
and remains with Europe, even though the
risk of a “euro divorce” is now much
lower than it was last year. Japan has
become the prime driver of global
monetary dynamics, having recently
helped to set off a third edition of “The
Great Monetary Easing.” The regime
changes in the administration and
subsequently at the Bank of Japan have
given the nation its best chance in two
decades of shaking off deflation and low
trend growth. Finally, EM growth is at risk
due to a decade-long loss of
competitiveness through real-exchangerate appreciation and misallocation of
resources.
What accounts for the 180-degree flip
in the world economy between 2009 and
2013? In our opinion, it boils down to how
well each economy’s institutions and
'7
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F
policies have deployed capital and
resources to productive activities—and if
capital was misallocated, have institutions
and policies been flexible enough to
correct the misallocation? While the role
of policy is stark, institutions play a role
that is often overlooked. Yet, institutions
that govern labor markets, regulations that
affect capital markets and sociopolitical
contracts that create differences in the
workings of markets across countries are
all critical to the direction of resources.
More importantly, all three can be changed
through structural reforms if they remain
an impediment to growth.
US FLEXIBILITY. In the US, excessively
easy monetary conditions, lack of
regulatory oversight and a private sector
that took institutional flexibility too far all
led to a misallocation of resources toward
the housing sector. Yet, rather ironically,
the same combination of easy money and
flexible institutions has also helped the
economy turn around. Despite the
headwind to growth induced by the
sequester, the private sector remains
resilient. This is in part due to flexible
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Economist
Morgan Stanley & Co.
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MANOJ PRADHAN
institutions and in part due to policy.
During the crisis, the flexibility in the
labor market raised unemployment to
north of 9% but also allowed the corporate
sector to protect itself; indeed, profits as a
share of GDP rose to record levels at a
time when that statistic could well have
applied to the corporate bankruptcy rate
(see chart below). To offset the dual
headwinds of uncertain personal income
growth and high indebtedness, aggressive
monetary policy was used to reduce debtservice costs to historically low levels.
This allowed households to reduce their
indebtedness and the government and
corporations to fund themselves. Banks,
once at the epicenter of the crisis, booked
losses early and have shown both the
ability and willingness to lend again (see
chart, page 3).
Make no mistake, the burdens of debtfacing households and the government
remain formidable, but prudent policy and
flexible institutions should mean that
steady deleveraging need not be
debilitating. How Quantitative Easing is
unwound will matter, as will
Washington’s willingness and ability to
reform the tax system to provide more of
an incentive to invest. Even then, the
promise of investment-led growth still
provides the US economy with the best
prospects for raising trend growth over the
next few years, in our view.
Source: Bureau of Economic Analysis, Morgan Stanley & Co. Research as of Dec. 31, 2012
Please refer to important information, disclosures and qualifications at the end of this material.
MORGAN STANLEY WEALTH MANAGEMENT | JUNE 2013
2 Banks Are Again Willing to Lend
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1,550
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Commercial Paper Outstanding
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EUROPE’S RIGIDITY. The rigidity of
Europe’s institutions, both economic and
political, helped to create the problem that
put the region at risk, and remains the
reason for its expected glacial pace of
recovery. Europe has made moderate
progress toward banking union and fiscal
union, as well as much more progress in
creating a lender of last resort thanks to
European Central Bank (ECB) President
Mario Draghi’s “whatever it takes” stance.
However, institutional rigidities that could
outlast policy changes create a lack of
synchronization of the business cycle in
the Euro Zone.
Why does this asynchronization exist?
First, European labor markets are still
fragmented, not just by language but also
by national social security systems. This
means that labor flows cannot really
correct the employment imbalances within
the Euro Zone. Second, there is no central
fiscal capacity, which could even out
cyclical differences through implicit or
explicit transfers.
Finally, the EU’s common monetary
policy is applied to countries with different
business cycles—a mismatch that means
risk imbalances and bubbles will likely
persist not just beyond this cycle, but even
in this cycle. The peripheral economies
warrant exceptionally low real and perhaps
even negative nominal rates, but this is not
necessarily what Germany needs. In the
process of providing protection for growth
in the peripheral economies, the ECB
could stoke above-trend consumption and
inflation in Germany and even engender
the risk of bubbles there.
Unless the institutional flexibility is
dealt with in order to create a more
synchronized European business cycle, or
monetary policy becomes flexible enough
to deal with the asymmetry of the region’s
current business cycle, Europe will have to
deal with economic volatility for the
foreseeable future.
JAPAN STARTS REFORM. Unlike the
Source: Federal Reserve as of May 15, 2013
end of the US housing boom, the bursting
of Japan’s housing bubble led to
stagnation that lasted for decades because
of the rigidity of its labor market and
corporate institutions and a more inflexible
monetary policy. Because these rigidities
were not tackled by policymakers,
conditions failed to improve. Instead,
capital left Japan to seek better returns and
a more hospitable environment for
manufacturing. The result was sustained
deflation that raised the real interest rate
above the nominal interest rate, making a
manufacturing revival even more difficult.
Japan’s stagnation demanded regime
change. A new regime was needed for
monetary and fiscal policy to fight
deflation and create policy-induced
support for growth, as well as for raising
productivity via structural reforms to
sustain the economic momentum.
A change in monetary policy has been
achieved and additional fiscal easing has
already been implemented. What remains
is what our colleague Robby Feldman calls
“third arrow policies”— microreforms
ranging from agriculture to energy,
employment, education and immigration
(see “‘Third Arrow’ Points to Japan’s
Future,” On the Markets, May 2013).
While some progress can be seen on some
fronts, we think it is still too little. Yet,
monetary and fiscal policies buy time for
the administration to deliver on third-
arrow policies, and this is where investor
focus is likely to shift, slowly but steadily.
EMERGING MARKETS TRANSITION.
EM economies missed an opportunity to
close the gap between them and their
developed-market counterparts. Thanks to
their well-functioning transmission
mechanisms and QE-related inflows,
policymakers were able to keep growth
strong. However, underdeveloped
institutions and misdirected policy moved
resources into activities whose returns
were (and are) falling. In the process of
staving off the fallout from the Great
Recession, EM economies relied on those
sectors that had delivered growth in the
precrisis period. These were the exportinvestment sectors in China, consumption
in India and the commodity sectors in
Russia and Brazil.
EM institutions, in most cases, are not
flexible enough to rectify the misallocation.
The burden of direction, and redirection,
of resources therefore falls on the
shoulders of policymakers. The growing
attention to structural reforms is an
important step in the process of correcting
misallocation. The prospect of emerging
markets regaining their stature in the
global economy depends on whether EM
economies can deliver the right structural
reforms (see “Why Is EM Under Fire,” On
the Markets, May 2013). 
3 ON THE MARKETS / EQUITIES
Technology: Where the
Cash Is
HERNANDO CORTINA, CFA
Senior Equity Strategist
A
modern-day Willie Sutton who
could choose a more edifying
profession would probably want to be a
technology investor. The reason is the
same as what attracted the legendary
bank robber: “it’s where the money is.”
Cash in the tech sector? Even with
the Great Recession and the ensuing
sluggish recovery, corporate America’s
overall cash position has grown rapidly
in the past few years, but nowhere has
the buildup of cash been greater than in
the tech sector. Of the more than $500
billion increase in cash that the top
1,500 US companies have amassed
during the past six years, $220 billion,
or 42%, has been in tech stocks. The
technology sector now has the most
balance sheet cash of the nine
nonfinancial sectors with $507 billion,
or 33%, of the $1.5 trillion in cash on
corporate balance sheets, followed by
the health care, industrials and
consumer discretionary sectors (see
chart).
AMASSING CASH. Technology
companies have been amassing cash for
many of the same reasons as nontech
companies. Managements want to
minimize the risk to their businesses of
a sudden credit crunch and strengthen
their balance sheets in the aftermath of
the deep recession and hesitant
recovery. With sluggish GDP growth,
many companies find themselves with
excess capacity that does not require
incremental new investment. The slow
growth has also made managements
cautious about embarking on large new
projects or acquisitions. Taxes play a
large role, too, as a portion of this cash
is domiciled overseas, and repatriation
would entail a significant tax expense.
Of course, large amounts of cash
alone do not necessarily imply an
attractive investment opportunity.
Whether that cash is appropriately
reflected in equity prices, together with
overall valuations and longer-term
growth prospects, are among the key
criteria. The cash on technology
companies’ balance sheets represents
approximately 16% of their market cap,
the highest of any sector, followed by
industrials at 12% and health care at
11%. Importantly, 16% is the highest
ratio of cash to market value in the
history of the tech sector, suggesting
that the current amount of cash is
particularly excessive and inefficient
from the perspective of tech equity
holders.
RETURN TO SHAREHOLDERS. With
cash yielding next to nothing and
depressing corporate returns on equity,
investors’ calls for it to be deployed or
returned via dividends or buybacks is
understandable. Tech companies have
always been significant buyers of their
own stock, in part to offset dilution
from employee stock compensation.
However, in light of the growing
amount of cash, the trend of some large
tech companies to initiate or boost their
dividends is certainly welcome.
Still, cash doesn’t tell the whole
story. Investors need to consider a
sector’s valuation relative to its history
and, in this regard, technology also
appears quite attractive. The 12-month
forward price/earnings ratio (FPE) of
the tech sector, currently at 13.4,
appears to be the most undervalued
sector based on its 10-year history; it
trades at a 21% discount to its average
over this period (see chart, page 5).
Granted, the 17 average FPE during the
10-year history is influenced by the
high multiples coming out of the boom
of the early 2000s. Nonetheless the gap
appears too wide. By contrast, utilities
and telecoms trade at 10% premiums
over this period while the market
overall is at about its average.
MARKET LAGGARD. Interestingly,
despite growing cash balances and
companies’ increasing inclination to
return them to investors, the tech sector
has lagged the market meaningfully
over the past 12 months, as well as year
Tech Sector Holds a Third of All Corporate Cash
Materials
4%
Utilities
1%
Consumer Staples
6%
Energy
7%
Telecom
2%
Technology
33%
dium
Consumer
Discretionary
15%
Industrials
16%
Health Care
16%
Source: Morgan Stanley & Co. Research as of Dec. 31, 2012
4 to date. Tech stocks are up 17% in the
past year, just about half the S&P 500’s
28% rise (through May 31). Year to
date, technology stocks are up 10%
versus the S&P’s 14%.
While this underperformance likely
reflects concerns about slowing growth
rates, both cyclically as well as perhaps
structurally, we believe these concerns
may be overdone. Tech companies
experienced a slowdown in the first
quarter as companies pared expenses
ahead of the start of the federal budget
sequestration on March 1. Because the
economic impact has not been as
negative as feared, there is potential for
companies to make postponed
purchases of software, hardware and
cloud services. It’s difficult to judge the
tech sector’s growth outlook beyond
five years, but we think it’s fair to say
that over the past three decades
innovation skeptics have much more
often proven wrong than right, and the
tech sector continues to attract some of
the most creative innovators.
FAVORED PLAYS. Within the
Strategic Equity Portfolio (STEP)
Program, we favor tech companies with
wide competitive moats, robust balance
sheets and cash flows, strong
management teams and reasonable
valuations. Themes and industries
Tech Stocks Appear Inexpensive Relative to Their
10-Year History
30
12-Month Forward Price/Earnings Ratio Relative to 10-year Average FPE
20
7.1
10
0.5
0.5
4.4
9. 8
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0
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Source: MSCI, Bloomberg as of May 31, 2013
currently represented in our portfolios
include smartphones and tablets, as
their global penetration continues to
increase; internet services and
advertising leaders; select enterprise
hardware and software leaders, as
corporate investments return; and
essential standard holders and licensors
in wireless communications.
Our other favored tech-related
industries include wireless towers,
which we view as key beneficiaries of
the rollout of LTE networks, as well as
credit card networks with their strong
secular growth arising from the
transition to electronic payments.
While they are not pure technology
companies and should be seen as more
closely tied to consumer expenditures,
we consider credit card networks to be
part of the tech sector. 
5 ON THE MARKETS / EQUITIES
period. Here’s how it works, using the last
50 years of the S&P 500 index as an
example.
●Share-price appreciation. From the
end of 1962 through the end of 2012, real
share prices grew at 2.7% per year,
roughly the same rate as real profit growth
and real GDP growth. Share prices and
real profit tend to grow at the same rate
because the price/earnings ratio (P/E)
tends to revert to a normal level of around
15—as long as the economy, inflation, and
interest rates are in a “normal” range of
stable longer-term levels. In fact, both
theory and the data show that a P/E ratio
of 15 is consistent with average returns on
equity of 13%, a real cost of capital of
about 7%, inflation of 2%, and long-term
profit growth of 2.5%.
●Cash yield. Over the 50-year period,
investors earned another 3.1% per year in
dividends and share repurchases, as
companies paid out around 55% to 65% of
their profits to shareholders. That payout
ratio, combined with an average P/E ratio
of 15, results in a cash yield on stocks
between 3% and 4% per year.
Payout levels may be volatile over the
short term, but over the longer term,
dividend and share-repurchase payouts are
driven by company cash flows—the
profits a company earns less the portion of
these profits it must reinvest to grow.
Anything left over must eventually be paid
Whither US Equity
Markets?
BING CAO
Consultant
McKinsey & Co.
BIN JIANG
Senior Expert
McKinsey & Co.
TIM KOLLER
Partner
McKinsey & Co.
U
S equity markets stretched once
again into record territory in May,
setting new highs on both the Dow Jones
Industrial Average and the S&P 500. Of
course, the question on everyone’s mind:
Where is the market headed next? In the
short term, of course, there’s no telling
what will happen. What really counts in
the long term is the market’s relationship
to the real economy.
In fact, much of the US equity market’s
performance, as we’ve seen over at least
the past 50 years, is clearly linked to the
performance of the real economy,
including GDP growth, corporate profits,
interest rates and inflation—in spite of
short-term volatility. In the absence of
some disruption of that link, the market
should continue to thrive. In a nutshell, if
GDP were to grow at rates comparable to
the 2%-to-3% annual real growth of the
past 50 years and inflation is kept in check,
investors should be able to expect annual
stock market returns of 5% to 7% in real
dollars over the next 10 to 20 years.
Today’s fundamentals make us
relatively sanguine about the market’s
performance over the longer term. Indeed,
it would take catastrophic changes in real
economic performance spread over
multiple decades in the real economy or a
fundamental shift in investor behavior—
unlike anything we’ve seen in more than a
century—to reduce long-term equity
returns to below around 5% in developed
markets. In this article, we’ll first examine
the connection between equities and the
real economy and then consider the likely
causes of breaks in that connection over
specific periods of time.
During the past century, stocks have
earned about 9% to 10% per year.
Adjusted for inflation, that means
investors have earned annual real returns
of about 6% per year. That 6% is no
random number and, in fact, is a natural
consequence of economic forces derived
from the long-term performance of
companies and industries in aggregate and
from the relationships of economic growth,
corporate profits and returns on capital—
and how they convert to total return to
shareholders (TRS).
Once these relationships are made clear,
the connection between the stock market
and the real economy becomes apparent,
and historical returns make sense: that is,
share-price appreciation combined with
cash yield has resulted in about 6% real
TRS—depending on the precise measuring
Potential Long-Term Real Returns to Shareholders
Today's Share Prices Relative to "Normal"
-20%
Long--Term
Earnings
Growth
10%
20%
2.0%
8.5
-10%
7.6
6.6
0%
5.6
4.4
2.5%
8.7
7.8
6.9
5.8
4.7
3.0%
8.9
8.1
7.1
6.1
4.9
3.5%
9.2
8.3
7.3
6.3
5.1
4.0%
9.4
8.5
7.6
6.5
5.4
dium
Note: Assumes return on capital is constant at 13% and inflation at 2%. Each percentage-point
increase in inflation reduces shareholder returns by about 0.5%, assuming companies cannot
increase their return on capital. Each percentage-point increase in return on capital increases
shareholder returns by about 0.2%.
Source: MSCI, Bloomberg as of April 30, 2013
6 back to shareholders, even among
companies that sit on their cash for years.
Combined, that level of share-price
appreciation and dividend yield results in a
total real return of 5.8% per year, slightly
lower than the 100-year average due to
recessions and high inflation in the 1970s.
It’s not inconceivable that fundamental
economic forces might tilt the balance and
undermine the equity markets. Radical
shifts in investor risk preferences, for
example, could permanently shift the longterm P/E ratio from 15 to some other
number. So could extreme changes in the
performance of the economy, such as
substantially higher or lower long-term
GDP growth or a large change in the ratio
of corporate profits to GDP, bigger than
the one that has taken place in recent years.
But such things haven’t happened thus
far, and as long as they don’t, shareholder
returns are unlikely to deviate much from
the 6% real long-term return. This analysis
assumes a constant 13% return on capital
and 2% annual inflation. If today’s stock
prices are considered normal, all the
outcomes from 2.0% to 4.0% real earnings
growth deliver better than a 6% return. In
fact, even with relatively extreme
assumptions about long-term earnings
growth, it is difficult to foresee real longterm shareholder returns of less than about
5%. 
Bing Cao is a consultant in McKinsey’s
New York office, where Bin Jiang is a
senior expert and Tim Koller is a partner.
For an unabridged version of the article,
which includes a historical perspective,
visit http://www.mckinsey.com/insights
Opinions expressed by them are solely
their own and may not necessarily reflect
those of Morgan Stanley Wealth
Management or its affiliates.
Copyright (c) 2013 McKinsey & Company.
All rights reserved. Reprinted by
permission.
7 ON THE MARKETS / ECONOMICS
and US protectionism. Further reforms in
Mexico—in particular an opening of the
energy sector and fiscal changes—could
provide greater and cheaper access to
energy, allow for deeper technological
exchange and let the public sector channel
more resources toward needed investments
in physical and human capital. If
successful, progress on reform should add
to the sustainability of Mexico’s
manufacturing rebound and lead to further
integration with the US, helping offset the
drag to exporters from a potentially
stronger exchange rate.
BLUEPRINT FOR CHANGE. Some of the
reforms that have already taken place
include more flexibility in the labor
markets and the first steps in an overhaul
of the education system aimed at
improving the quality of schooling, as well
as the launch of a bill aimed at boosting
competition in the telecom and media
sectors. However, among the many
initiatives delineated in the “Pacto por
Mexico”—a blueprint for reform that
received multiparty support—the greatest
boost to industry should come from a
comprehensive opening of the oil and
natural-gas sectors. If successful, allowing
foreign and private investment in these
two critical areas could translate into
significantly higher levels of investment
and technology transfer. The impact on
Playing the US
Manufacturing
Comeback—in Mexico
Mexico's Share of US Imports Near Historic Highs
13%
12
Other Manufacturing
11
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China Overlap *
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ow do you play a potential US
industrial renaissance? Invest in
Mexico. Because of its strong links to the
US industrial sector and improved
competitive standing, we believe that
Mexico’s manufacturing sectors are in a
unique position among the major emerging
market (EM) economies to benefit from a
revival in US manufacturing. As such, we
see the Mexican peso and the country’s
industrial, petrochemical, rail and real
estate investment trust sectors as
beneficiaries.
Mexico’s competitive position in
manufacturing has been improving for
several years. Mexico’s market share of its
principal export destination—the US—is
near historical highs (see chart). Its
market-share gain has played a role in
boosting manufacturing production, which
during this cycle has benefited
disproportionately from better US factory
output. On the investment front,
machinery and equipment outlays have
maintained a strong uptrend and there have
been several announcements of major
commitments, mainly in the transportation
sector. Factory jobs and car production,
meanwhile, are at record highs, as are
industrial exports. What’s more, industries
such as automobiles and aerospace parts
have been the brightest spots, other sectors
that have traditionally faced intense
'0
1
H
D
ec
Latin America Economist
'0
0
Mexico Equity Strategist
LUIS ARCENTALES
competition and stagnation—such as
textiles, furniture and white goods—also
appear to be on better footing.
STRUCTURAL REFORM. Still, Mexico
needs to make further progress on its
structural reform agenda in order to move
up the value chain, in our view. The good
news is that the prospects for much needed
structural reforms, namely “Mexico’s
Moment,” are better today than in more
than a decade. To understand the
sustainability of Mexico’s benefits from its
strong link to the US industrial sector, we
divide the drivers into two categories:
those in which Mexico excels through its
own performance, and those in which it
benefits from external factors over which
it has little or no control.
True, Mexico deserves credit for the
restructuring in its manufacturing sector,
but much of its success is based on
external factors such as the surge in shale
gas output, rapidly rising wages in China
D
ec
NICKOLAJ LIPPMANN
D
ec
*Includes toys, major applicances, air conditioners, apparel and textiles
Source: USITC, Morgan Stanley & Co. Research as of April 29, 2013
8 Higher Wages in China Have Added to Mexico’s
Increasing Manufacturing Competitiveness
$2.50
Hourly Manufacturing Wages
industry, moreover, could be material
thanks to cheaper and greater access to
natural gas and electricity.
ENERGY REFORM. It is important to
note that Mexico depends more on natural
gas than the US, using gas for 46% of its
energy—part of it imported from the
States—versus 30% for the US. Even so,
growth of Mexican manufacturing has
been driven by less energy-intensive
sectors. This could imply that Mexico has
a problem with the availability of gas for
marginal projects, as highlighted by
recurrent episodes of gas rationing by
Pemex, the state-owned oil company.
Comprehensive energy reform,
hypothetically, could change this by
setting up a framework that would allow
the company to explore its vast gas
reserves with partners. If successful, an
associated benefit of bringing private
capital into the energy sector would be to
free up resources—currently running at
2.0% of GDP—earmarked for Pemex
capital expenditures, which could then be
redirected toward needed infrastructure
investment.
If Mexico’s energy sector were to see a
period of growth similar to that in the US
since the end of 2009, we estimate that the
direct impact from rising output—without
considering the impact from demand in
other sectors and capital deepening from
greater investment—could add roughly
half a point to GDP growth per year.
THE CHINA EFFECT. China’s entrance
into the WTO in 2001 created an
important negative supply shock for
Mexico because 45% of Mexican exports
are in similar categories as Chinese
exports, according to the International
Monetary Fund. Within a period of only a
few years, Mexico faced an emerging
manufacturing powerhouse 10 times its
size competing in similar markets. Today,
Mexico’s industrial sector has restructured
and increased its specialization. For
example, the once-strong textile industry
in Mexico is a fraction of what it was in
2001, while the automobile and auto parts
Mexico
2.00
1.50
dium
1.00
China
0.50
2002 2003 2004 2005 2006 2007 2008 2009* 2010* 2011* 2012*
*Estimates for China
Source: ILO, SHCP, INEGI, Morgan Stanley & Co. Research as of April 29, 2013
sectors—which have stronger synergies
with the North American automobile
complex—are much larger. Mexico’s
industrial sector appears to have increased
focus in certain ecosystems and boosted its
integration with its US counterparts. As
the US has moved down its value chain,
Mexico has become a just-in-time partner
with a convenient location and
inexpensive sourcing, rather than a fullblown competitor.
Mexico’s commercial relationship to
the US has boosted specialization and
economic complexity. Despite lack of
innovation and its spending on R&D,
technology transfer from the US has
allowed Mexico to earn the 20th spot
globally (out of 129 countries) on the
Economic Complexity Index tracked by
the Center for International Development
at Harvard University. Within Latin
America’s 21 countries, Mexico ranks first.
Highly ranked countries are those that are
able to hold vast amounts of productive
knowledge, and that manufacture and
export a large number of sophisticated
goods. The innovation may not be
Mexican but, thanks to a solid engineering
base, relatively few problems with
intellectual property rights and close
integration with the US, Mexico appears to
be reasonably well positioned to continue
to benefit from technological transfer and
increased complexity within the US
production chain. Furthermore, the close
relationship between the two countries
helps the US remain competitive in laborintensive manufacturing and move farther
down the manufacturing value chain, a
process that is important for economic
growth and that may accelerate in coming
years.
RECOVERY DRIVERS. All told, we
believe Mexico deserves credit for several
of the drivers that have led to its recovery,
including a stable and predictable macro
framework in terms of fiscal, monetary
and trade policy; efforts to reduce red tape;
a commitment to trade openness; and a
free-floating exchange rate. The North
American Free Trade Agreement has no
doubt played a pivotal role, as has the
resilient corporate sector, which has been
successful at keeping unit labor costs in
check. In addition, Mexico provides a
more attractive environment for
multinational corporations concerned
about piracy, copyrights and protection
from industrial espionage than some of its
Asian competitors. 
The preceding article is an excerpt from
a Morgan Stanley & Co. Research Blue
Paper, “US Manufacturing Renaissance:
Is It a Masterpiece or a (Head) Fake,”
April 30, 2013.
9 ON THE MARKETS / FIXED INCOME
ending the program. We believe investors
need to gird themselves for this sort of
bond-market volatility and begin the
process of lessening duration* in their
fixed income portfolios.
CREDIT SPREADS WIDEN. If credit
spreads were the only way to measure
performance of the investment grade and
high yield bond markets, one could be
forgiven for thinking both asset classes
fared well during the past month. Yet
nothing could be further from the truth.
Investment grade spreads have tightened
roughly three basis points since the
beginning of May, and recently hit a postfinancial crisis low of 127 basis points.
However, because of the sell-off in
Treasuries, the yield on the Citi Broad
Investment Grade Corporate Index is up
26 basis points for the month, which has
resulted in net spread widening of roughly
23 basis points.
High yield spreads are wider for the
month, with the Citi High Yield Market
Index only nine basis points wider monthto-date (through May 29). However, on a
net basis, the index has actually widened
45 basis points, due to a 36 basis-point
increase in yield. In fact, the high yield
index hit an all-time high price of 107.72
on May 9; since then, the spread widened
36 basis points, the yield climbed 62 basis
points and the price fell 1.89 points.
Bonds Swoon Over
Jobs Data
KEVIN FLANAGAN
Chief Fixed Income Strategist
JOHN DILLON
Chief Municipal Bond Strategist
JONATHAN MACKAY
Senior Fixed Income Strategist
B
lame it on jobs. Since May 3, when
the US Labor Department reported a
higher-than-expected 165,000 payroll gain
for April, the US Treasury market has
taken a slide. The positive economic news
surprised bond investors and dashed the
perception of a slowdown in the labor
market, pushing the yield on the
benchmark 10-year US Treasury note up
more the 30 basis points by mid May.
Then, on May 22, speaking of Quantitative
Easing 3 (QE3), Federal Reserve
Chairman Ben Bernanke told the Joint
Economic Committee of Congress that if
the Fed were to see sustained
improvements in payrolls in the coming
months, “in the next few meetings [the
Federal Open Market Committee] could
take a step down in the pace of
purchases.”
Now, the yield on the 10-year note is at
levels last seen more than a year ago (see
chart). Prior to this renewed bout of
selling pressure, the note drew in buyers
when the yield reached the 2.05% mark.
Near term, we thought this trend would
continue, but ultimately, the stage would
be set for a move toward the top of our
range, namely 2.25%.
HEIGHTENED VOLATILITY. The big
question is where will Treasury yields go
in the months ahead? For starters,
uncertainty surrounding the Fed’s asset
purchases will most likely linger over the
summer and lead to heightened volatility.
In fact, the 50-basis-point swing in May
underscores this point. Morgan Stanley
Wealth Management's Technical Analysis
Group says that the 10-year note, having
pierced the first level of resistance at
2.08%, faces the next one at 2.28%. Break
through that, and 2.40% could be in play.
Since October 2011, the market twice tried
to penetrate that level and fell back.
The yield on the 10-year note is now at
its highest since April of last year. We
believe that the 10-year yield has more
room to rise to the upside this year, but we
don't see this as the “Great Rotation” to
stocks from bonds. Forces remain in place
that will help contain higher yields:
lackluster economic growth, disinflation,
Euro Zone risk, and, of course, the Fed.
Although Bernanke started the second
wave of selling pressure at the back end of
the curve, it is important to remember the
discussion revolves around scaling back
asset purches or “tapering” QE3, not
Treasury Yield Follows Jagged Path
2.50%
10-Year US Treasury Yield
2.20
1.90
dium
1.60
1.30
Oct '11
Jan '12
Apr '12
Jul '12
Oct '12
Jan '13
Apr '13
Source: Bloomberg as of May 28, 2013
10 suffering from an abrupt rise in Treasury
yields. In investment grade, we
recommend three-to-seven-year maturities.
This part of the credit curve—less duration
exposure than long-term credit and higher
income than short-term credit—has
outperformed both longer and shorter
maturities on a year-to-date basis and we
expect it will continue to do so in the near
term. Despite the recent sell-off, we think
high yield valuations remain rich. The
risk/reward for high yield investors has
become asymmetric, and thus we advise
investors to either improve the quality of
their holdings or reduce exposure to the
asset class (see page 12). Within high yield,
we recommend two-to-seven-year BBrated credits over CCC-rated issues.
SEASONAL SHIFT FOR MUNIS. Due to
the backup in US Treasury yields,
municipal bond yields have also risen in
the last month. Now, seasonal factors in
the muni market are about to shift, with
the summer months typically a period of
low supply (see chart). It’s also a period of
high demand, thanks to scheduled coupon
payments and redemptions. Before the
arrival of the low-supply July-AugustSeptember period is June, which is
historically one of the heaviest months for
primary market issuance.
The combination of recent muni
outperformance and expected supply
Summer Is the Slow Season for Muni Issuance
$50
2013 Supply
Par Value (Billions)
SWEET SPOTS. Both asset classes are
2000-to-2012 Average
40
30
20
10
0
y
y
ch
ar
ar
ar
ru
nu
M
b
a
J
Fe
ril
Ap
y
Ma
Ju
ne
Ju
ly
st
er
er
er
er
gu
mb ctob emb emb
Au p te
c
v
O
De
No
Se
Source: Bond Buyer as of May 31, 2013
leaves the municipal market vulnerable to
downside volatility in the coming weeks
which, we believe, may offer a compelling
entry point. Investors looking to put cash
to work should watch for weeks of robust
issuance, about $7 billion to $8 billion.
Given the rapid rise in interest rates during
May, investors should focus on both
absolute yields, which are over 50 basis
points higher than the November 2012
lows for benchmark 10-year munis, and
municipal relative value, which is likely to
improve once the larger supply kicks in.
DOWNGRADE RISK. As always,
investors need to guard against downgrade
risk, specifically in local government
bonds. For this reason, in generalobligation bonds, we prefer bonds with
ratings of mid-tier A or higher. We also
suggest extending prudently on the credit
curve to capture value in distended credit
spreads, namely essential-service revenue
bonds with ratings of mid-tier BBB and
higher.
We believe that the maturities between
five and 11 years offer good value without
taking outsized interest rate risk. Close to
65% of the yield available throughout the
30-year yield curve is currently captured
by year 11; nearly two-thirds of all yield in
the market resides in just over one-third of
the total maturity range. We also continue
to advocate investing in defensive
structures with above-market coupons.
Pre-refunded bonds look compelling when
trading at near parity with US
Treasuries.
*Duration, the most commonly used measure of bond risk, quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The
longer the duration, the more sensitive the bond or portfolio would be to changes in interest rates. Generally, if interest rates rise, bond prices fall and
vice versa. Longer-term bonds carry a longer or higher duration than shorter-term bonds; as such, they would be affected by changing interest rates for a
greater period of time if interest rates were to increase. Consequently, the price of a long-term bond would drop significantly as compared to the price of
a short-term bond.
11 ON THE MARKETS / FIXED INCOME
takeaway is that many investors wary
of rising rates have been buying short
yield-to-call bonds, which makes this
slice of the high yield market somewhat
vulnerable in the event rates surprise to
the upside. While he does not advocate
investors sell all of their short yield-tocall paper, he does say investors should
be aware of extension risk and look
into “bullet bonds,” which are bonds
that cannot be called before maturity.
We agree on this point and although
we are not favorable on high yield
bonds in general, we see some value in
pockets of the market for investors who
believe the Federal Reserve’s massive
liquidity injections will support risk
assets for a longer period than we do.
To allow investors to buy bonds with
no calls, we extended our maturity
range by two years, so the range is now
two to seven.
We suggest investors looking to add
high yield exposure take advantage of
bullet bonds at the longer end of our
range and callable bonds at the shorter
end of the range, depending on the
structure of the call and the credit risk.
We continue to advocate keeping credit
quality high as lower-quality bonds
(CCCs) look to be trading well beyond
what fundamentals warrant, in our
opinion. 
High Yield Bonds:
More Downside Risk Than
Upside Potential
Senior Fixed Income Strategist
T
he high yield market has defied
expectations this year. Despite
slowing inflows and strong new
issuance activity—technical factors that
are typically negative for the market—
high yield has outperformed all other
fixed income asset classes from a total
return perspective and set some
valuation records along the way. The
Citi High Yield Market Index, up
5.04% year to date (through May 28),
recently reached an all-time high dollar
price of 107.72 and an all-time low
yield of 4.93%. In addition, the index’s
spread over US Treasuries fell to its
lowest level since the onset of the
financial crisis in 2008.
NEGATIVE CONVEXITY. So far, so
good, but in our view, high yield bonds
now have more downside risk than
upside potential. The primary reason
for our view is that the high yield
market now has “negative convexity,”
which is a condition in which further
price gains are limited because of the
call options embedded in many high
yield issues. Essentially, as interest
rates come down, refinancing becomes
attractive for companies, which raises
the risk that issuers will exercise those
calls. Many high yield bonds are now
trading at prices that presume they will
be refinanced on their stated call date.
This limits the upside of the market and,
if interest rates rise, the bonds face
extension risk. That means instead of
bonds trading to their nearby calls, they
start trading as longer-term bonds,
which results in lower prices.
More than 66% of the Citi High
Yield Market Index is callable at an
average price of 104.2 (see chart).
What’s more, roughly 77% of those
bonds are trading as though they will
be called on their next call date rather
than trading to maturity. As rates rise,
the prices of these callable bonds
should drop and they could start trading
to their maturity date. Thus, instead of
trading to a call date that is two or three
years off, they could trade to their final
maturity date, which extends the
duration of the bond. (See duration risk
disclosure on page 11).
VULNERABLE MARKET SEGMENT.
Adam Richmond, high yield analyst for
Morgan Stanley & Co., discussed these
risks in a recent report (Duration When
You Least Expect It, May 3, 2013). His
High Prices for High Yield Bonds
110
100
Average Call Price
90
80
Price
70
60
dium
P T
- wo Medi um F
Citi High Yield Market Index
50
40
n'
9
M 1
ar
'9
M 2
ay
'9
3
Ju
l'9
4
Se
p'
9
N 5
ov
'9
6
Ja
n'
98
M
ar
'9
M 9
ay
'0
0
Ju
l'0
Se 1
p'
0
N 2
ov
'0
Ja 3
n'
05
M
ar
'0
M 6
ay
'0
7
Ju
l'0
Se 8
p'
0
N 9
ov
'1
0
Ja
n'
12
M
ar
'1
3
JONATHAN MACKAY
Ja
Source: The Yield Book as of May 24, 2013. © 2013 Citigroup Index LLC. All rights reserved.
12 ON THE MARKETS / ALTERNATIVES
Alternatives Abound in
Mutual Funds
MATTHEW RIZZO
Head of Investment Strategy & Content
Consulting Group Investment Advisor Research
Morgan Stanley Wealth Managment
T
he popularity of alternative
investments has increased
considerably over the past decade, as
investors have sought vehicles with the
potential for more consistent results, lower
correlation to the overall stock market and
a greater focus on absolute return. For the
most part, alternative investments are the
province of hedge funds, which, because
of their high minimum investments, net
worth hurdles and limited liquidity, are not
available to many individual investors.
However, an increasing number of
alternative mutual funds have come along,
allowing more investors access to a
number of different types of alternative
strategies with experienced management
teams, reasonable account minimums and
greater portfolio transparency relative to
hedge funds.
Of course, alternative mutual funds
encompass many different asset classes
and strategies because an alternative
investment can be any asset that is not a
stock, bond or cash. Under the alternatives
umbrella there are options and futures,
leveraged equity or bonds, private equity,
currencies, commodities, master limited
partnerships and real estate investment
trusts; it may even include collectibles
such as paintings or other works of art, or
luxury items such as wine and spirits.
Often, alternative strategies seek to
provide competitive returns relative to a
given benchmark while at the same time,
potentially limiting downside risk in the
event of a market downturn, although
objectives vary widely depending on the
fund’s strategy.
LOWER MINIMUMS AND FEES. The
main objectives of most hedge funds and
alternative mutual funds are to provide
investors with attractive risk-adjusted
returns, achieve low correlation to
traditional markets and increase portfolio
diversification. However, unlike hedge
funds, SEC-registered open-end mutual
funds that seek alternative-like exposure
have lower investment minimums and fees,
greater portfolio transparency, daily
liquidity and provide daily pricing.
While alternative mutual funds offer
some advantages, because of legal
limitations, mutual funds that seek
alternative-like exposure generally must
utilize a more limited investment universe
and, therefore, are expected to have
relatively higher correlation with
traditional market returns compared to
hedge funds (see table, page 14).
Additionally, registered open-end funds
are statutorily limited in their use of
leverage, short sales and the use of
derivative instruments as compared with
hedge funds. As a result of these
differences, performance for a mutual fund
that seeks alternative-like exposure and its
portfolio characteristics may vary from a
hedge fund that is seeking a similar
investment objective. Historically, hedge
funds in certain categories have enjoyed a
performance advantage relative to their
mutual fund counterparts.
CORRELATION WITH HEDGE FUNDS.
Underperformance notwithstanding, most
of the alternative mutual fund category
returns examined showed fairly high
correlation with their comparable hedge
fund category returns, indicating that the
diversification benefits afforded by hedge
funds may be available using alternative
mutual funds. This was done using
Morningstar data to compare alternative
mutual fund category returns to applicable
hedge fund index returns across 14
different alternative subcategories. During
the past five years (period ending
December 31, 2012), correlations between
alternative mutual fund category returns
and the comparable hedge fund index
returns ranged from high (above +0.90) for
categories such as commodities, natural
resources and REITs, to moderate (+0.60
up to +0.90) for long/short equity,
managed futures, global macro, tactical
allocation, merger arbitrage, event driven
and multialternative, to low (less than
+0.60) for equity market neutral,
diversified arbitrage and currency. The
correlation patterns were fairly consistent
over the 15-year period (ending December
31, 2012) as well, but the number of
alternative mutual funds in existence for
the full period was much smaller.
Fund-tracker Morningstar estimates that
about $14 billion flowed into alternative
mutual funds on a net basis in calendaryear 2012. As of year end, there was
approximately $89 billion invested in
alternative mutual funds, which is a new
high-water mark for the asset class.
Additionally, during the past 10 years,
alternative mutual fund assets have
increased at an annualized rate of about
31% per year. Separately, research from
Cerulli Associates recently showed that
money managers expect assets they hold in
alternative investments to increase by at
least 50% over the next three years. Cerulli
also forecasts that alternative mutual fund
assets could represent about 10% of all
fund assets in five years, up from nearly
3% currently.1
MULTIALTERNATIVE FUNDS. One of
the fastest-growing categories recently has
been multialternative, which incorporates
multiple alternative investment strategies.
13 Morningstar estimates that the category’s
2012 asset flow equaled more than 40%
of its start-of-the-year assets. Total assets
now equal about $16 billion. Other
smaller, faster-growing categories include
long/short equity and bear market, where
asset flows equaled more than 80% and
100%, respectively, of their start-of-theyear assets. By the year’s end, long/short
equity reached approximately $15 billion
and bear market funds, $6 billion. Asset
flows for alternative mutual funds using a
managed futures strategy equaled more
than 10% of beginning assets over the
past year and total assets were about $8
billion at year-end 2012.
Some investment professionals believe
that, as investors become more familiar
with alternative investment strategies and
as their use continues to grow, we could
continue to see further segmentation,
thereby increasing the number of
different types of alternative strategies. A
larger universe of specialized alternative
mutual fund vehicles provides
opportunity for more tailored investment
implementation, but it also may increase
risk if the implementation is mishandled,
the strategy misfires or if a client simply
does not fully understand the strategy’s
risk/return profile. 
1
Alternative Mutual Funds Versus Hedge Funds
Alternative Mutual Funds
Hedge Funds
Style
Varies by strategy
Varies by strategy
Flexibility
Limited investment flexibility
Greater investment flexibility
Derivatives
Limited use of derivatives
Greater ability to use
derivatives
Leverage
Limited use of leverage
Greater ability to use
leverage
Transparency
High
Generally low
Correlation
Generally higher to traditional
investments
Generally lower to traditional
investments
Minimums
Low minimums
High/private investor
qualifications
Fees
Typically asset-based
management fees
Typically management and
performance fees
Tax Reporting
IRS Form 1099
Typically IRS Form K-1
Redemptions
Generally daily
Limited opportunity to redeem
Oversight
1940 Act restrictions
Limited SEC oversight
Diversification
Requirements
Position sizes, sector
exposure, etc.
None—diversification varies
widely
Investment
Operations
Regulatory
Source: Consulting Group Investment Advisor Research as of April 29, 2013
Jeff Benjamin, “Alternative mutual fund strategies set for rapid growth: Cerulli,” Investment News, July 17, 2012
14 Important Notice Regarding Complex Products
The type of mutual funds discussed in this report on pages 13 & 14 utilize non-traditional or complex investment strategies and/or
derivatives. Examples of these types of funds include those that utilize one or more of the below noted investment strategies or categories
or which seek exposure to the following markets:






Commodities (e.g., agricultural, energy and metals), Currency, Precious Metals
Managed Futures
Leveraged, Inverse or Inverse Leveraged
Bear Market, Hedging, Long-Short Equity, Market Neutral
Real Estate
Volatility (seeking exposure to the CBOE VIX Index)
You should keep in mind that while mutual funds may at times utilize non-traditional investment options and strategies, they should not be
equated with unregistered privately offered alternative investments. Because of regulatory limitations, mutual funds that seek alternativelike investment exposure must utilize a more limited investment universe. As a result, investment returns and portfolio characteristics of
alternative mutual funds may vary from traditional hedge funds pursuing similar investment objectives. Moreover, traditional hedge funds
have limited liquidity with long “lock-up” periods allowing them to pursue investment strategies without having to factor in the need to
meet client redemptions. On the other hand, mutual funds typically must meet daily client redemptions. This differing liquidity profile
can have a material impact on the investment returns generated by a mutual fund pursuing an alternative investing strategy compared with
a traditional hedge fund pursuing the same strategy.
Non-traditional investment options and strategies are often employed by a portfolio manager to further a fund’s investment objective and
to help offset market risks. However, these features may be complex, making it more difficult to understand the fund’s essential
characteristics and risks, and how it will perform in different market environments and over various periods of time. They may also
expose the fund to increased volatility and unanticipated risks particularly when used in complex combinations and/or accompanied by the
use of borrowing or “leverage.”
15 Global Investment Committee
Tactical Asset Allocation
The Global Investment Committee provides guidance on asset allocation decisions through its various
model portfolios. The eight models below are recommended for investors with up to $25 million in
investable assets. They are based on an increasing scale of risk (expected volatility) and expected
return.
CONSERVATIVE
MODERATE
MODEL 1
MODEL 2
5% High Yield
5% Emerging
Markets
Fixed Income
1% Inflation-Linked
Securities
3% Diversified
Commodities
57% Investment
Grade Fixed Income
5% Hedged Strategies
1% Managed Futures
2% REITs
3%
Emerging
Markets
Fixed
Income
32% Cash
MODEL 3
5% Diversified
Commodities
2% Managed Futures
2% REITs
17%
Cash
8% US
Equity
42%
Investment
Grade Fixed
Income
10%
International
Equity
4% High Yield
5% Emerging
Markets
Equity
3%
Emerging
Markets
Fixed
Income
12%
Cash
12% US
Equity
33%
Investment
Grade Fixed
Income
13%
International
Equity
3% High Yield
8% Emerging
Markets
Equity
MODERATE
MODEL 4
6% Diversified
Commodities
MODEL 5
2% Managed Futures
8%
Cash
3% REITs
2%
Emerging
Markets
Fixed
Income
7% Diversified
Commodities
MODEL 6
2% Managed Futures
7% Cash
3% REITs
15% US
Equity
17%
International
Equity
18% US
Equity
1%
Emerging
Markets
Fixed
Income
21%
International
Equity
1% High Yield
2% High Yield
26%
Investment Grade
Fixed Income
10% Emerging
Markets
Equity
17%
Investment Grade
Fixed Income
13% Emerging
Markets Equity
8% Diversified
Commodities
2% Managed Futures
3% REITs
1%
Emerging
Markets
Fixed
Income
6% Cash
22% US
Equity
25%
International
Equity
7%
Investment Grade
Fixed Income
15% Emerging
Markets Equity
AGGRESSIVE
MODEL 7
11%
Hedged Strategies
3% Managed Futures
5% Cash
17%
Emerging
Markets Equity
11%
Hedged Strategies
3% Managed Futures
5% Cash
8% Diversified
Commodities
8% Diversified
Commodities
3% REITs
MODEL 8
25% US
Equity
28%
International
Equity
19% US
Equity
3% REITs
20%
Emerging
Markets Equity
KEY
CASH
GLOBAL FIXED INCOME
31%
International
Equity
GLOBAL EQUITIES
ALTERNATIVE INVESTMENTS
Note: Hedged strategies consist of hedge funds and managed futures.
16 Tactical Asset Allocation Reasoning
Global Equities
US
Relative Weight
Within Equities
Underweight
We recently decreased our exposure on a relative basis. The US has led the global recovery from
the financial crisis, owing to its more aggressive monetary and fiscal policies. At this stage, relative
valuation and the rate of change in policy and growth look more attractive in other regions.
International Equities (Developed
Markets)
Equal Weight
We recently increased our exposure to Japan and Europe. In Japan, a meaningful political change
has taken place, leading to significant currency depreciation, which should be bullish for equity
prices. Economic growth and structural issues remain in Europe, but they are well known and
priced in, making this an attractive region over our seven-year strategic time horizon.
Emerging Markets
Equal Weight
Policymakers’ focus has generally shifted away from containing inflation toward supporting growth,
with room for further stimulative measures.
Global Fixed Income
US Investment Grade
International Investment Grade
Relative Weight
Within Fixed Income
Overweight
We recommend investors hold shorter maturities given potential capital-loss risks associated with
the current record-low yields. For example, a 20-basis-point increase in rates can wipe out the
entire annual yield on a 10-year bond. Within investment grade, we prefer corporates and
securitized debt to Treasuries.
Equal Weight
Yields are low globally so not much additional value accrues to owning international bonds beyond
some diversification benefit.
Inflation-Linked Securities
Underweight
With significantly negative real rates all along the yield curve, we see little value in these securities
at the moment. There are better ways to hedge inflation risk.
High Yield
Underweight
Yields are near record lows while the upside is capped due to call provisions on many of
these issues.
Emerging Markets Bonds
Alternative Investments
Equal Weight
With spreads and yields at record lows, we recently moved to Equal Weight from Overweight.
Relative Weight
Within Alternative
Investments
REITs
Equal Weight
Further upside appears limited if interest rates begin to rise, but property markets continue to
recover in the US, making this an acceptable risk.
Commodities
Equal Weight
Monetary easing is accelerating on a global basis, which historically has been associated with
higher commodity prices, especially in the precious-metals sector. China’s weak GDP performance
has been weighing on industrial commodities, but China’s economy is starting to stabilize.
Hedged Strategies (Hedge Funds
and Managed Futures)
Equal Weight
We recently decreased our exposure to hedged strategies to further diversify our overall allocation
to alternatives. This asset class can provide uncorrelated exposure to equity and other risk-asset
markets and tends to work well in periods of difficult financial market conditions.
17 ON THE MARKETS
Index Definitions
DOW JONES INDUSTRIAL AVERAGE A
widely
followed indicator of the stock market, the Dow
is a price-weighted average of 30 blue-chip
stocks that are generally the leaders in their
industries.
S&P 500 INDEX Regarded as the best single
gauge of the US equities market, this
capitalization-weighted index includes a
representative sample of 500 leading companies
in leading industries of the US economy.
CITI BROAD INVESTMENT GRADE INDEX This
index tracks the performance of US-dollardenominated bonds issued in the US investment
grade bond market. It includes institutionally
traded US Treasury, government-sponsored,
mortgage, asset-backed and investment grade
securities.
CITI US HIGH YIELD MARKET INDEX The
index
includes publicly issued US-dollar-denominated
non-investment grade, fixed-rate, taxable
corporate bonds that have a remaining maturity
of at least one year, are rated high yield using the
middle rating of Moody’s, S&P and Fitch,
respectively, and have $600 million or more of
outstanding face value.
18 ON THE MARKETS
Disclosures
Morgan Stanley Wealth Management (“Morgan Stanley Wealth Management”) is the trade name of Morgan Stanley Smith Barney LLC, a registered
broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of
any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to
future performance.
The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors,
including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors.
Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material.
This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any
security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own
independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision,
including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain
material information not contained herein and to which prospective participants are referred. This material is based on public information as of the
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warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated
information on the securities/instruments mentioned herein.
The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will
depend on an investor’s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate
specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary
because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or
financial conditions of companies and other issuers or other factors. Estimates of future performance are based on assumptions that may not be realized.
Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events
not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling
purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not
represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be
realized or that actual returns or performance results will not materially differ from those estimated herein.
This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not
intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a
fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as
amended in providing this material.
Morgan Stanley Wealth Management and its affiliates do not render advice on tax and tax accounting matters to clients. This material was not
intended or written to be used, and it cannot be used or relied upon by any recipient, for any purpose, including the purpose of avoiding penalties
that may be imposed on the taxpayer under U.S. federal tax laws. Each client should consult his/her personal tax and/or legal advisor to learn about
any potential tax or other implications that may result from acting on a particular recommendation.
This material is primarily authored by, and reflects the opinions of, Morgan Stanley Wealth Management Member SIPC, as well as identified guest authors.
Articles contributed by employees of Morgan Stanley & Co. LLC (Member SIPC) or one of its affiliates are used under license from Morgan Stanley.
International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic
uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these
countries may have relatively unstable governments and less established markets and economies.
Alternative investments which may be referenced in this report, including private equity funds, real estate funds, hedge funds, managed futures funds, and
funds of hedge funds, private equity, and managed futures funds, are speculative and entail significant risks that can include losses due to leveraging or
other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification,
absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees
than mutual funds and risks associated with the operations, personnel and processes of the advisor.
Managed futures investments are speculative, involve a high degree of risk, use significant leverage, have limited liquidity and/or may be generally illiquid,
may incur substantial charges, may subject investors to conflicts of interest, and are usually suitable only for the risk capital portion of an investor’s
portfolio. Before investing in any partnership and in order to make an informed decision, investors should read the applicable prospectus and/or offering
documents carefully for additional information, including charges, expenses, and risks. Managed futures investments are not intended to replace equities
or fixed income securities but rather may act as a complement to these asset categories in a diversified portfolio.
Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i)
changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and
terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change
and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions
due to various factors, including lack of liquidity, participation of speculators and government intervention.
19 Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond’s maturity, the more sensitive it is to this risk.
Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity
date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally
invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the
issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment
risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.
Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater
credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances,
objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.
Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT).
Typically, state tax-exemption applies if securities are issued within one's state of residence and, if applicable, local tax-exemption applies if securities are
issued within one's city of residence.
A taxable equivalent yield is only one of many factors that should be considered when making an investment decision. Morgan Stanley Smith Barney LLC
and its Financial Advisors do not offer tax advice; investors should consult their tax advisors before making any tax-related investment decisions.
Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their
business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.
Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high
valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.
Treasury Inflation Protection Securities’ (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by
tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to
inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation.
Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
Interest income from taxable zero coupon bonds is subject to annual taxation as ordinary income even though no interest payments will be received by the
investor if held in a taxable account. Zero coupon bonds may also experience greater price volatility than interest bearing fixed income securities because
of their comparatively longer duration.
Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and
market risks.
Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market
risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign
inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition,
international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic
uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these
countries may have relatively unstable governments and less established markets and economies.
REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited
diversification and sensitivity to economic factors such as interest rate changes and market recessions.
Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the
performance of any specific investment.
The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth
Management retains the right to change representative indices at any time.
Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.
Credit ratings are subject to change.
Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be
offered or sold absent an exemption therefrom. Recipients are required to comply with any legal or contractual restrictions on their purchase, holding,
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This material is disseminated in Australia to “retail clients” within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management
Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813).
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20 Morgan Stanley Private Wealth Management Ltd, which is authorized and regulated by the Financial Services Authority, approves for the purpose of
section 21 of the Financial Services and Markets Act 2000, content for distribution in the United Kingdom.
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© 2013 Morgan Stanley Smith Barney LLC. Member SIPC.
21

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