GLOBAL INVESTMENT COMMITTEE APRIL 2013 Positioning Shifting Paradigm? Commodities and emerging market (EM) equities have been underperformers for two years. Their highs coincided with the global growth peak in early 2011 and social unrest caused by the too rapid rise in energy and food costs. This underperformance makes sense to me, but the recent decline seems to be excessive, particularly in light of new stimulus measures by the Bank of MICHAEL WILSON Chief Investment Officer Morgan Stanley Wealth Management M.Wilson@morganstanley.com +1 212 296-1953 Japan (BoJ) and rising consensus expectations for an increase in global growth later this year. There has been some disappointing near-term growth data from around the world. Nevertheless, the moves in commodities, inflation expectations and securities sensitive to inflation expectations have moved much more dramatically than I would have anticipated if the second-quarter slowdown were only temporary, as we expect. To put these market moves into context, we looked at the relative performance of US stocks that are highly correlated to inflation expectations compared to the MSCI All Country World Index (see Exhibit 1, page 2). Our analysis shows the recent underperformance of inflation-sensitive stocks rivals the decline we saw during the 2008-09 financial crisis and in 2011 when risk markets were plunging worldwide. This time around, these stocks’ poor showing is occurring as global equity markets appear to be consolidating rather than plunging while some markets—most notably, Japan— appear to be breaking out. These results do not seem to be consistent with one another. We have been anticipating a slowdown in economic growth during the second quarter and a correction in equity prices, which is reflected in our current tactical asset allocation (see Strategic and Tactical Asset Allocation Change, March 8, 2013). While the economic data has indeed weakened, the correction has thus far been contained to the more economically sensitive areas of the equity market. That may be all we get, but the correction could broaden out before it’s over if past experience is a guide. Furthermore, while our tactical US equity risk model has moved out of the high-risk zone, it has not yet moved into the low-risk area where we prefer to add equity exposure. The bottom line is that volatility is on the rise in the short term, led by currencies, commodities and Japanese government bonds. These are far from stable, so we prefer to remain patient and follow our indicators. Follow us on Twitter @ MSWM_GIC 1 POSITIONING looking for, we think lower inflation expectations support continued easy monetary policy. It also suggests to me that certain emerging markets could finally start to perform better, at least on a relative basis. Exhibit 1: The Negative Relative Performance of Inflation-Sensitive Stocks Has Been Extreme The Real “Great Rotation” 425 0.095 375 0.090 0.085 325 0.080 275 0.075 0.070 0.76 Defensive Sectors Performance Relative to the Cyclical Sectors 0.74 0.72 0.70 0.68 0.66 0.64 0.62 0.60 Apr-13 This does not have to be a subpar outcome for equity markets in the aggregate. After all, lower inflation via stronger currency could be quite stimulative in other regions. As an example, Brent crude oil priced in Indian rupees is currently down 9% on a year-over-year basis. Also, lower headline inflation could provide cover to the world’s other central banks to offer more monetary stimulus, if necessary. We could have a new paradigm for how to think about Quantitative Easing (QE) and the recovery from the global financial crisis. Most important, whether or not we get the tactical correction in equities we are Exhibit 2: Investors Appear to Prefer Income-Producing Stocks Feb-13 Upon deeper reflection, Japan’s actions could be disinflationary. How’s that? For the past 20 years, Japan has been the world’s shock absorber, allowing its currency to appreciate dramatically against virtually all others while suffering with deflation. As a result, global growth accrued to those countries with the weaker currencies. Now, it seems Japan wants to partake in the global recovery, which could result in less growth for others. By creating its own inflation, Japan could be exporting deflation to everyone else. Dec-12 What else could Mr. Market be telling us? I’ve thought long and hard about this, and believe the inconsistent message of weakening commodity prices and stable equity prices could be suggesting a more significant shift in the broader investment landscape. A newly introduced factor for investors to consider is the BoJ’s decision to enter the global currency race to the bottom. At first blush, one might think this is inflationary for global markets, including commodities. Oct-12 Source: Bloomberg as of April 16, 2013 Aug-12 Dec-31-12 Jun-12 Dec-31-11 Apr-12 Dec-31-10 Feb-12 Dec-31-09 I try to be data driven and ignore such hyperbole even though it’s difficult to avoid getting caught up in the excitement. The press and many analysts have highlighted this year’s strong inflows to equity mutual funds as evidence of the Great Rotation. However, this conclusion might be overly simplistic. An analysis by Matthew Hornbach, interest rate strategist for Morgan Stanley & Co., shows that the source of flows into equities is cash, not the sale of fixed income securities. In addition, our proprietary Morgan Stanley Wealth Management data shows that our clients are simply reinvesting cash they raised during the fourth quarter of 2012, when they sold equities ahead of expected tax hikes. So far, it appears they have redeployed only about half of the total raised late last year. Finally, it seems the stocks most in demand are still the “bond like” equities that exhibit defensive and/or income-generating characteristics (see Exhibit 2). Our analysis indicates investors are showing a heavy preference for income even with their Dec-11 125 Oct-11 0.055 Dec-31-08 175 Aug-11 0.060 You can always count on the financial world to come up with acronyms and catch-phrases for the latest trend. Currently, that tag line is the “Great Rotation,” a reference to the eagerly anticipated shift from fixed income securities to stocks. The concept seems plausible and is bullish, which is why mainstream media and the public have so readily adopted it. Jun-11 0.065 225 Inflation-Sensitive Stocks Relative to S&P 500 (left scale) MSCI All Country World Index (right scale) MSCI All Country World Index Price Inflation Sensitive Stocks Relative to the S&P 500 0.100 Source: Bloomberg as of April 12, 2013 Please refer to important information, disclosures and qualifications at the end of this material. Morgan Stanley Wealth Management | April 2013 2 POSITIONING Exhibit 3: Japanese Households Are Heavy on Cash, Light on Equities Japan (As of December 2012) Insurance and Pensions 28% Other 4% Equities 7% Mutual Funds 4% Fixed Income 2% Cash and Deposits 55% US (As of December 2012) Insurance and Pensions 28% Euro Zone (As of September 2012) Insurance and Pensions Equities 33% Other 3% Cash and Deposits 15% Fixed Income Mutual Funds 10% 12% 32% Other 4% Cash and Deposits 36% Equities 14% Mutual Funds 7% Fixed Income 7% Source: Bank of Japan; Japanese Ministry of Finance; The Wall Street Journal Market Data Group equity investments. This is in line with the Global Investment Committee’s preference for quality and dividend growth stocks in the US. Interestingly, defensive, income-producing stocks are not outperforming in Japan. Instead, early-cycle stocks that are generally sensitive to rising inflation expectations are doing better. This divergence of internal market performance between Japan and developed markets could be supportive of the thesis that Japan is indeed exporting deflation as it creates inflation for itself. While we do not envision a Great Rotation from bonds to stocks in the US, it could happen in Japan. After 20 years of deflation and perhaps the most persistent bear market in modern times, Japanese policymakers have decided to go “all in” with their reflation efforts. We’ve seen this before, as many earlier attempts at QE in Japan eventually failed. Perhaps in making a new and more assertive effort than prior attempts, policymakers were inspired by the apparent success of the US’ far more aggressive monetary policy. Japan may also be motivated by its first monthly current account deficit last November. That was the game changer, in my opinion, but whatever the reason, Japan is now committed to the most aggressive monetary policy in the world, including that of the Federal Reserve. To put the Bank of Japan’s recent announcement into perspective, it plans to buy as much as the Fed is buying (about $80 billion per month), even though Japan’s economy is only one-third the size of the US’. Understandably, the yen has continued to weaken against all currencies and is now down about 22% over the past nine months, according to the Westpac Nominal Effective Exchange Rate Trade-Weighted Index. In a world of currency wars, Japan has taken the lead, which could spark a real Great Rotation. Japanese households are underinvested in equities relative to their US and European counterparts as equities account for only 7% of household assets versus 33% in the US, and 14% in the Euro Zone (see Exhibit 3). The MSCI Japan Index is up 60% since November 2012 in local terms and 32% in US dollars. Bloomberg data shows Japan has been the best-performing major equity market since the yen began its most recent depreciation. I don’t think this pace is sustainable, but the currency trend seems durable and if Japan follows up with real structural reforms, stock market trends could also remain more durable than investors expect. Some commentators suggest that Japan’s potential gain would be purely cosmetic and that the country’s structural reform will remain absent. They also advise US investors to avoid the Japanese stock market because they believe potential gains will be eaten up by currency movements. Robby Feldman, Japan economist for Morgan Stanley & Co., counters the naysayers. He believes there will be some real attempts at structural reform this time (see Japanese Economics: J-Insight: The Third Arrow: Can Abenomics Maintain Momentum? April 4, 2013) Second, equity returns have significantly outpaced the currency losses for non-yen investors since November, a trend that could continue. Investors could hedge their currency risk if they choose. However, I would not recommend a full hedge since doing so increases the beta, and downside risk, of the investment. Until now, many foreign fund managers have used Japan’s currency move as an excuse for avoiding Japanese equities. However, this excuse could be Please refer to important information, disclosures and qualifications at the end of this material. Morgan Stanley Wealth Management | April 2013 3 POSITIONING 1.7 15% 11% 10.9 9.8 1.6 0.7 Emerging Markets Source: I/B/E/S, FactSet as of April 12, 2013 wearing thin as managers may need to consider removing their long-standing underweight positions in Japan given currencyadjusted returns of Japanese equities are starting to materially outpace other regions. All of this could be fuel for higher Japanese equity prices. Finally, I think Japan is now an emerging growth story, and perhaps the most attractive growth story globally. Exhibit 4 (see page 4) illustrates that Japan’s earnings growth potential is significant and, on a relative basis, much greater than the other major regions shown. As a result, Japan could be the most compelling regional equity investment opportunity in the world. There will surely be bouts of uncertainty and doubt, especially as we approach the summer when structural reforms are expected. I recommend using such corrections to position appropriately rather than chasing here. What if QE Works? During the past few months, there has been a growing chorus suggesting the US and perhaps even the global economy is finally on the verge of reaching escape velocity, thus breaking free of the plodding growth of the post-financial-crisis period. Morgan Stanley & Co. economists call it moving from “twilight to daylight,” although they still believe we are likely to suffer below-trend growth as the world deleverages (see Spring Global Macro Outlook: From Twilight to Daylight, March 12, 2013). Nevertheless, economies are healing, and markets are always about rate of change, and we think the rate of change on growth should be positive in the second half of 2013. For equities, I believe what matters is earnings growth, not GDP growth. This is why US equities have dramatically outperformed other regions for the past few years, including the emerging markets where economic growth has been far superior. I think this connection gets lost sometimes. Not to belabor the Even the Fed has doubted the efficacy of QE in terms of its impact on the real economy. But, what if QE actually achieves its stated goals of lower unemployment and greater economic growth? I am fairly certain the consensus view on such an outcome is gaining traction, despite the anticipated secondquarter economic slowdown. I also suspect most investors believe such an outcome would be desirable. However, if growth were to remain positive but subpar, central banks may opt to keep policy loose, which could translate to a potentially better outcome for equity markets. For example, consider when March’s weak payroll data were released: Equity markets initially sold off sharply, but then rallied back as investors realized such disappointing data could delay the Fed’s eventual exit from QE for longer. It seems everyone is trying to figure out when this cyclical bull market will end. I think the end of this cycle will be no different from any other—it will likely end when the Fed says so. The main distinction this time will be that the Fed has said explicitly what it will take to end it—a 6.5% unemployment rate or inflation above 2.5%. With such visible targets, markets are likely to react as we get closer or farther away from these targets. In other words, if QE actually works, the cycle could end sooner. Exhibit 5: In Earnings Revisions, Japan Has Shown the Greatest Gains 20% MSCI USA MSCI Europe MSCI Japan MSCI Em erging Markets 10% 0% -10% -20% -30% -40% Sep-12 1.5 Sep-11 11.1 Sep-10 12.5 Sep-09 12% Sep-08 7% Sep-07 1.9 Europe Sep-06 0.6 2.2 Sep-05 1.1 12.8 Sep-04 14.3 14.3 Sep-03 21.2 12% Sep-02 49% 7% Sep-01 35% US Sep-00 Price/ Earnings to Growth 2013 Sep-99 Japan Price/ Book Ratio 2012 Sep-98 Price/ Earnings Ratio 2013 2014 Sep-97 MSCI Index Consensus EPS Growth 2013 2014 point, but near-term earnings growth appears to be greatest in Japan, followed by the emerging markets, the US and Europe. What may be most striking are the prices being paid for this respective earnings growth. On a P/E-to-growth basis, Japan is by far the cheapest (see Exhibit 4). Finally, upward earnings revisions, or the rate of change on earnings growth, have also been the greatest in Japan (see Exhibit 5), lending further support to the region’s recent positive performance. Sep-96 Exhibit 4: Potential High Earnings Growth Makes Japan Attractive Source: Bloomberg as of March 31, 2013 Please refer to important information, disclosures and qualifications at the end of this material. Morgan Stanley Wealth Management | April 2013 4 POSITIONING For the record, I don’t think past QE measures have worked with regard to the Fed’s stated goals nor do I believe that was ever the real intention. However, this is my single biggest concern for risk markets with respect to the end of cycle. While the recent soft global economic data may ironically extend this equity market cycle, the BoJ’s recent move to mimic the Fed could accelerate its end. By exporting deflation, Japan may force other central banks to become even more aggressive perhaps helping QE to achieve its stated goals. The good news is that we know what to watch as a warning sign given the very explicit guidance from the Fed.  Please refer to important information, disclosures and qualifications at the end of this material. Morgan Stanley Wealth Management | April 2013 5 POSITIONING Index Definitions MSCI ALL WORLD COUNTRY This free- float-adjusted market-capitalization index is designed to measure equity market performance in the developed and the emerging markets. WESTPAC NOMINAL EFFECTIVE EXCHANGE RATE TRADE-WEIGHTED INDEX JAPANESE YEN This trade- weighted index is a geometric average of bilateral exchange rates between Japan and its major trading partners. 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. MSCI JAPAN INDEX This free-float- adjusted capitalization-weighted index is designed to track the equity market performance of Japanese securities on the Tokyo, Osaka and Nagoya Stock Exchanges as well as the JASDAQ. MSCI USA INDEX This free-float-adjusted capitalization-weighted index is designed to measure large- and mid-cap US equity market performance. MSCI EUROPE INDEX This free-float adjusted capitalization-weighted index is designed to measure the performance of 16 developed European markets. MSCI EMERGING MARKETS INDEX This free-float-adjusted market-capitalization index is designed to measure equity-market performance in the global emerging markets. Disclosures 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. 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