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GLOBAL INVESTMENT COMMITTEE / COMMENTARY

SEPTEMBER 2013

On the Markets
MICHAEL WILSON Chief Investment Officer Morgan Stanley Wealth Management

Back to School
Early September is a time for transition, often from leisurely days at the pool or beach to a pile of to do lists. Children face the anxiety of entering the next grade, while mom and dad contemplate their own challenges at work. Markets are anxious, too. September historically is the weakest month of the year for US equities and has consistently delivered negative returns. Perhaps this anomaly is just a reflection of market participants combined personal anxieties butmore than likelyit is the fact that real transitions in the economy and geopolitical events tend to occur at this time of year.
So far, 2013 has not disappointed, with several important inflection points now occurring simultaneously. First, the global economy continues to improve at very different speeds around the world. Surprising many has been the recovery in Europe and, as a result, European stocks have quickly assumed a leadership role in global equity markets since late June. Second, throughout the globe, we have seen significant changes in policy. The long-awaited tapering of asset purchases by the Federal Reserve is expected to begin this month, just as Japan tries to implement real structural reform. Finally, the tragic events in Syria remind us that tensions in the Middle East remain ever present. All of this is causing investors some uncertaintyand opportunity. This months On the Markets provides a summary of Morgan Stanley & Co.s triannual update on the global economy and markets. In general, Morgan Stanley & Co.s economics and strategy teams believe the global economy continues to heal from the financial crisis of 2008 and 2009. In a switch from the past decade, the developed economiesnot the emerging economiesare the ones with momentum. Hence, developed markets should continue to lead equity market performance. The mid-cycle correction in risk assets that began in May, marked by a jump in longterm interest rates, is likely to persist for at least a few more weeks or months. While there could be a flight to quality and subsequent decline in interest rates in the near term, we do not think that would be a trade worth playing. Instead, we continue to favor stocks over bonds and anticipate divergent performance across regions and sectors. Stay underweight benchmark duration within fixed income and look to add equities in Japan, Europe and the US during the traditionally weak month of September.

TABLE OF CONTENTS

Forecasting Slower Global Growth Struggling emerging economies lead Morgan Stanley & Co. to lower global economic growth forecasts. US Economy: From Resilience to Sustained Expansion In the US, we see economic acceleration for the rest of this year and 2014. Bullish on the Developed Markets Data shows thats where the growth isand the best equity market prospects. Make Room for Global Gorillas These big companies with global footprints are still attractive investments. Equity Investors Return to Europe Debt and fiscal issues aside, equity markets have plenty of positive momentum. Higher Rates Need Not Sink Stocks History shows that growth stocks performed well in periods of rising interest rates. Fast-Rising Interest Rates A volatile market causes bond yields to break through old targets. The Great EM Unwind Powerful macro forces are buffeting the emerging economies. Q&A: PIMCOs Mohamed El-Erian El-Erian talks about the New Normal, monetary policy and the Feds next leader.

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ON THE MARKETS / ECONOMICS

Lowering Our Global Forecast


GLOBAL ECONOMICS TEAM Morgan Stanley & Co.

ack in March, we predicted an acceleration of global growth to an above-trend pace in the second half of 2013 and in 2014. Six months later, the narrative has started to ring true for developed-market (DM) economies but certainly not for the emerging market (EM) economies. EM growth has surprised to the downside. While we had been highlighting the broken growth models and the structural challenges since the middle of 2012, weve still been disappointed by the incoming data this year. Thus, in our June forecast, we cut the outlook for several large EM economies, including China, Brazil, Mexico, Korea and South Africa, and noted further risks for EM growth. REAL RATES HURT. Since then, better growth prospects for DM economies and related fears of less accommodative monetary policy have pushed global real interest rates significantly higher, weighing heavily on EM assets, currencies and economies. In several EM countries, central banks have been forced to tighten policy in an attempt to stem further capital outflows and currency depreciation. The tightening was explicit in Indonesia, India and Turkey and implicit in Brazil and South Africa, as well as EM economies that have external balance sheet exposure. As a consequence, we are lowering our sights on EM growth further, implying a significant reduction to our aggregate global GDP forecast.

CUTTING GLOBAL FORECAST. We now expect global GDP growth of 2.9% in 2013 and 3.5% in 2014, down from our previous 3.1% and 3.9% forecasts, respectively (see table.) Our downgrade is driven entirely by dimmer prospects for virtually all EM economies. We now forecast EM GDP growth of only 4.8% this yearwhich is 0.3 percentage points less than previouslyand just 4.9% in 2014, down from 5.7%. Our biggest cumulative forecast cuts in 2013 and 2014 are in India, Brazil, Thailand, Turkey, Mexico and Ukraine. We have also downgraded our 2014 China forecast to 7.1% from 7.6%, but we are keeping our 7.6% forecast for this year, given the recent signs of stabilization. CAUTIOUSLY OPTIMISTIC. Even with lowered forecasts for the EM economies, we believe DM growth will be strong enough for us to maintain a cautiously optimistic view on the current global economic cycle. The first half of the cycle, which started after the

Great Recession, was led by China and the other EM economies. Now in the second half, the US and other DM economies are the leaders. We see DM GDP growth doubling to 2.0% in 2014 from 1.0% this year. More specifically: Our full-year 2013 GDP forecast for the US has come down to 1.6% from 1.9% previously, but this entirely reflects a weaker-than-expected first half. Our 2014 forecast stays at 2.7%. Our Japan numbers are unchanged for both this year and next, with some downside risk in the near term, given recent weaker-than-expected consumer data. We see some upside risk for 2014, as the 3.0 percentage-point hike in the consumption tax due next April, which we have already built into our forecast, may not be implemented in full. In the Euro Zone, our 2013 estimate goes up marginally to -0.5% from -0.7%, reflecting an earlier-thanexpected return to growth in 2013s second quarter. Our 2014 forecast remains 0.9%. We are making a meaningful upward revision to our UK forecast, with 2013 GDP growth going to 1.4% from 1.0%, and 2014 moving to an above-consensus 2.4% from 1.4%. We think that the UK has finally reached a sustainable recovery.

Morgan Stanley's Real GDP Forecasts


Region Global Developed Economies US Euro Zone Japan UK Emerging Economies China India Brazil Russia 2012 3.2% 1.5 2.8 -0.5 2.0 0.2 4.9 7.7 5.1 0.9 3.4 2013E 2.9% 1.0 1.6 -0.5 1.6 1.4 4.8 7.6 4.4 2.1 2.2 2014E 3.5% 2.0 2.7 0.9 1.3 2.4 4.9 7.1 4.6 1.7 3.1 2015E 3.7% 2.0 2.6 1.2 1.3 2.1 5.2 6.9 6.0 1.6 2.8
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Source: IMF, Morgan Stanley & Co. Research as of Sept. 2, 2013

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

ON THE MARKETS / ECONOMICS

US: From Resilience to Sustained Expansion


VINCENT REINHART Chief US Economist. Morgan Stanley & Co.

he US economy has traversed a rocky road thus far in 2013: significant serious fiscal drag, concerns about the Feds withdrawal of policy stimulus and the faltering expansion of key emerging markets. However, in the first half, average real GDP growth was in excess of 1.75% annualized.That may appear unimpressive, but looks are deceiving. We read the first-half outcome as masking significant momentum in private spending. Indeed, the economys resilience makes us more confident that the expansion can climb out of the 2% channel of the past few years to one centered a touch below 3%. The level of activity is marking an upward inflection point right about now. Four factors support our case for a 2.75% average growth rate for real GDP in 2014 and 2015 (see chart): Peak fiscal drag is behind us. Tax increases and spending cuts mandated by sequestration cost the economy about 1.75% of nominal GDP this year. However, the restraint was partly frontloaded, and the consequences of the tax changes were well telegraphed. This implies a lessening drag on the growth of spending through the years end. The financial crisis of 2008 and 2009 is farther behind. Financial intermediaries have de-levered and derisked, and households have lowered debt relative to income. This follows the historical script: The first five years after a severe crisis typically involve a

severe and lengthy recession, a hesitant recovery and a subpar expansion. After five years, economic expansion resumes around the precrisis pace. We are now entering that later phase. The healing is clearly manifest in housing. Residential investment has become an above-trend contributor to growth and house-price appreciation is adding to household wealth. The backup of mortgage rates in the past few months slows this momentum, but home affordability remains attractive. Equity price gains and houseprice appreciation have significantly added to household wealth. Over time, this will provide a powerful inducement for additional spending. As managers see higher sales and expected further gains, they will accelereate capital spending. In the Morgan Stanley & Co. forecast, business fixed investment expands above 2.25% this year and then grows

at a 6.0% rate in 2014 and 2015. Uncertainty about government policies has fallen from last year, increasing businesses willingness to spend. Moreover, increased energy exploration and extraction should fuel investment in structures and manufacturing. This assumed quickened pace in capital spending is the outlooks key uncertainty. Managers may view their cash hoards as insurance or be concerned about overcapacity. Moreover, in recent years, investors have punished firms that announce capital spending plans and rewarded those that buy shares or hike dividends. Note, however, that this factor is a mechanism amplifying the impetus to spending from the others. Even if capital expenditures do not step up, we are still likely to exit the first halfs soft patchbut we will not get the extra lift needed for more rapid expansion. With subdued inflation, Fed action will be keyed to the unemployment rate, which in our forecast tips below 6.5% in early 2015, the threshold the Fed has staked out for raising its policy rate from its zero floor. We believe that the Fed will tighten policy steadily thereafter, with the federal funds rate ending 2015 at 1.5%.

US GDP Growth Reaching for Sustained Expansion

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Source: Bureau of Economic Analysis, Morgan Stanley & Co. Research as of Sept. 2, 2013
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

ON THE MARKETS / STRATEGY

Bullish on the Developed Markets


GLOBAL STRATEGY TEAM Morgan Stanley & Co.

he recent acceleration in economic growth in the developed markets is further evidence that these economies would transition from the twilight zone the fuzzy area between recession and solid recoveryinto the daylight of abovetrend growth. However, this transition also means exiting the sweet spot of unusually low interest rates and accelerating earnings growth that allowed markets to perform so well year to date. We expect this transition to be a volatile but temporary adjustment and not an endof-cycle event for the global economy, so our strategic stance is unchanged: We maintain a constructive view of developedmarket (DM) risk assets over a six-month investment horizon. However, during the next one to two months, we expect higher volatility and a continuation of the midcycle correction that began in May/June, which may well produce an entry point for becoming more aggressive on risky assets across the board. The two main risks to this scenario are another sharp move higher in core bond yields and a more disorderly unwind in the emerging markets. Of the two risks, we are more concerned about the emerging markets because the problems are based not only on rising financial market stress but also the structural problems accumulated over the last decade. We do expect US bond yields to work their way higher and peak at around 3.36% this time next year. That said, investor sentiment toward bonds is already

extremely bearish, and so a countertrend rally is possible between now and the years end. In addition, the yield curve is almost at its steepest level in 40 years (see chart). While that doesnt put a cap on a potential rate rise, it does suggest that the 10-year note would have a hard time rising more than 30 to 40 basis points from current levels without a large change in rate-hike expectations. Stabilization in DM bond yields would ease but not eliminate the pressure on emerging markets, because material structural problems remain in a number of key economies (see page 12). However, we also believe that emerging market (EM) fundamentals are more diverse and

better able to adjust than was the case during past periods of extreme stress, such as in 1997 and 1998. Having said this, we note that overall EM valuations are not yet at trough levels. As such, our base case is for ongoing adjustment and associated EM volatility, but not an extreme case of across-the-board contagion driven by an outright, sudden stop of global financial flows. Here are the outlooks for the various asset classes: We continue to favor equities over credit and government bonds on a three-to-six-month horizon. Neither equities nor credit are cheap in a long-term context, but neither is expensive. History suggests they will richen further until the current cycle peaks. Higher bond yields do not necessarily pose a threat to DM equities at this stage of the cycle. In fact, comparing the real earnings yield on equities with the real yield on 10-year government bonds, we find that equities are near their long-term average

Treasury Yield Curve Nears 40-Year High

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Source: Bloomberg as of Aug. 29, 2013

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

based on data that goes back to 1881 (see chart). Also from a valuation perspective, the MSCI World Indexs price/book ratio is slightly less than two; it is only at the 73rd percentile of its 20-year range and it stands well below the levels reached in the mid-to-late-cycle environment of 2003 to 2007. Our economists are forecasting DM growth of 2% in 2014, up from an expected 1% in 2013, which should serve as a basis for further equity market gains. According to Morgan Stanley & Co. estimates, the best-performing equity market for the next 12 months is Japan, with a base-case 21% gain on the TOPIX index. Our base-case forecast for the S&P 500 is 12% (see table). Core government bonds remain a strategic underweight, but are more two-way near term. We expect the US 10-year note to rise further to 3.36% over the next 12 months. However, near-term bearish investor sentiment toward bonds has reached levels normally associated with a countertrend rally. Not all regions should deliver negative total returns over the next three to six months. We prefer US Treasuries and Japanese government bonds over German bunds and UK gilts; the periphery over semi-core in Europe; and Russia, Colombia and Peru within the emerging markets. Emerging markets have cheapened, justifying less bearishness. In equities we continue to prefer developed markets to emerging markets, but in fixed income we note better valuations and return prospects and hence upgrade from underweight to neutral. In both cases, the difference lies in the risk/reward skew. Credit should still beat government bonds. Like equities, valuation of the credit sector is no longer cheap, but still

Japan Is Still Our Preferred Region


Region/Benchmark Index Japan/TOPIX* US/S&P 500 Europe/MSCI Europe* Asia Pacific ex Japan/ MSCI Asia Pacific ex Japan Emerging Markets/MSCI Emerging Markets 14 12 46 45 -37 -38 Upside to Price Target 21% 12 1 8 Upside to Bull Scenario 42% 42 29 Downside to Bear Scenario -22% -18 -22

*Local-currency return Source: REIMS, Morgan Stanley & Co. Research as of Aug. 27, 2013

Equities Appear More Attractive Than Bonds on a Long-Term Basis

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*Real earnings yield is real prices divided by the 10-year moving average of real earnings.

Source: Federal Reserve, Robert J. Shiller, Bloomberg, Datastream, Morgan Stanley & Co. Research as of Aug. 30, 2013

short of expensive. Securitized credit remains our favorite segment, but the strong performance for the year to date is approaching our strategists bull case. We cut Asia credit to underweight because of deteriorating fundamentals and deleveraging in China. Europe remains our preferred region for corporate credit. The US dollar rally should broaden. We remain dollar bulls. The rally we

anticipated has been concentrated on the EM axis thus far, and we expect this picture to broaden out with gains against DM currencies during the next six months.

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

ON THE MARKETS / EQUITIES

Make Room for Global Gorillas


HERNANDO CORTINA, CFA Senior Equity Strategist Morgan Stanley Wealth Management DAN SKELLY Equity Strategist Morgan Stanley Wealth Management

ust weeks ago, we published a thematic investment report entitled Global Gorillas 2013, identifying our top 30 US and overseas stock picks from within the universe of large, global companies. This report is a follow-up to our initial 2011 report, when global gorillas were identified as one of Morgan Stanley Wealth Managements key investment themes. We admit the timing of the report might seem curious. Economic growth outside the US so far this year looks wobbly at best, and US equities have materially outperformed non-US stocks for nearly four years. Whats more, Morgan Stanley & Co. economists forecast that US GDP growth is likely to be the highest among the major developed economies in 2014. So wouldnt we want to emphasize domestically oriented stocks over their more global counterparts? We think emphasizing global gorillas continues to make sense, as we expect: quality stocks will pay off over time; the rate of change of growth and policy overseas is improving; attractive secular trends, such as a rapidly expanding middle class in the emerging markets, remain intact; and valuations are relatively attractive compared with smaller-cap stocks. We view quality as an enduring investment strategy. While economic forecasts are often murky, we continue to believe that focusing on companies with global footprints, strong balance sheets,

wide competitive moats, proven management teams and significant freecash-flow generation is a winning strategy long term, particularly when they are trading at reasonable valuations. Each of our global gorillas is a best-in-class company with a leading global franchise, as well as a higher-than-average profit margin and return on equity. Each is now trading at what we view as a modest valuation premium relative to the S&P 500. Their revenues are also well diversified by region (see chart). Overseas economic rates of change are improving. Our economists believe that we may be approaching a turning point in the growth and policy environment overseas. Japan has embarked on a three-part economic program of monetary stimulus, fiscal

consolidation and structural reform aimed at exiting the deflationary environment of the past two decades. In Europe, systemic risks to sovereign debt and the banking system have declined sharply and growth appears to have turned modestly positive, though structural changes to the European Unions economic framework are still necessary. Emerging markets are experiencing pressures stemming from the normalization in US interest rates and, though some specific countries may experience greater pressure than others, we dont expect the generalized contagion that was seen in 1998. The emerging markets have become much more flexible and resilient since then, and they continue to grow faster than developed economies. In fact, the most recent data suggest that China, the largest emerging market (EM) economy, continues to grow at a steady pace of between 6% and 7%. We continue to find attractive bottom-up secular trends in EM economies. While the near-term growth picture for many EM economies appears less robust, we continue to find appealing

Global Gorillas Revenue by Region

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Source: Bloomberg, company data as of Aug. 21, 2013

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

longer-term trends. These include the 40% expansion in the number of middle-class consumers by 2017, projected by the International Labor Organization. This bodes well for our picks in food and beverages, beauty care, electronic payments and e-commerce. We also point to stocks exposed to the increasing value of entertainment media content, expanding wireless infrastructure investment and Chinas necessary and growing focus on improving its air and food quality. There are tactical opportunities, too. In the equity rally of the past several years, high-quality stocks have not always been in favor. Indeed, we note that, coming off the 2009 bottom and through 2010, there was an extreme divergence in performance between low-quality companiesthose with weaker balance sheetsand their higher-quality and, often, larger-cap counterparts. While not quite as dramatic, in 2012 and into this year, there has been a similar pattern of smaller-cap, higher-risk companies outpacing large-cap, quality stocks. Illustrating the lagging performance of the higher-quality stocks, the Russell 2000 Index, a small-cap benchmark, returned 42% since year-end 2011, while the mega-cap Russell Top 50 Index, a proxy for global gorillas, has returned just 31%. Furthermore, the valuation of larger-cap US stocks relative to the smaller-cap universe is quite compelling (see chart). All told, we

Large-Cap Stocks Remain Relatively Attractive in Comparison With Small-Cap Stocks

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Source: Morgan Stanley & Co. Research as of July 31, 2013

believe that during the next two years there is more risk-adjusted potential in the global gorillas than in the overall equity market. Of course, there are risks to the globalgorilla thesis. As with all global investing, currency fluctuations can be an issue and, in this case, an outsized strengthening in

the US dollar could negatively impact the overseas revenues of US-domiciled stocks when those sales are translated into dollars. In addition, a further slowing in the emerging markets could have a detrimental impact on the companies with higher relative exposure to this region.

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

ON THE MARKETS / EQUITIES

Investors Return to European Equities


KRUPA PATEL European Equity Analyst Morgan Stanley & Co. International PLC

nce wary of Europe because of the seemingly intractable sovereign debt issues, severe fiscal problems in several Euro Zone countries and a sclerotic economy, global investors are now returning to European equities. There is no place better to spot their return than in relative market performance. While year to date the MSCI Europe Indexs 10.3% significantly trails the MSCI USA Indexs 16.8%, the momentum is shifting. Europe is ahead 7.5% to 2.7% for the quarter to date. Index returns are as of Aug. 30. In our view, the renewed interest in Europe likely reflects two factors. First, valuations and total returns are at the lower end of their long-term ranges, particularly versus those of the US. Second, the news suggests Europe has stabilized. LOW VALUATION LEVELS. Europes markets are trading near a 40-year low in valuations versus the US. In comparison with the States, Europes relative price/book ratio is in the fifth percentile and price to dividend in the 17th percentile. On a conventional price/earnings (P/E) basis, Europes relative P/E to the US is about average. However, using the Shiller P/Eprice divided by 10-year average real earningsEuropean stocks are near an all-time low versus the US. In addition, the sharp drop in European bond yields relative to US Treasuries has helped to lift European stocks, but not to the

degree that the interest rate differential would suggest (see chart). Earnings could help, too. The relative gap between European and US earnings is at a 30-year low. However, the outlook for European profits is improving and our margin lead indicator suggests we may finally see margin expansion in 2014. LOWER SYSTEMIC RISKS. Investors also perceive that systemic risk has fallen materially. For instance, credit default swaps (CDS) have fallen back to where they were just prior to the decision to haircut Greek bonds two years ago; peripheral bond spreads are also the tightest in two years. CDS spreads for senior financial institutions have been halved during the past 12 months. Bond spreads in the fiscally challenged peripheral members of the Euro Zone have narrowed, too.

Finally, the economic growth outlook is improving. The Citi Economic Surprise Index for Europe is currently above that of the companion US indexa rare event during the past couple of years. Whats more, the gap between Europes composite Purchasing Managers Index (PMI) and the Institute of Supply Managements composite PMI has closed significantly. Historically, Europes PMI leads upturns in return on equity (ROE). ATTRACTIVE SECTORS. We find that the most attractive European sectors versus their US counterparts are utilities, insurance, banks, energy and autos. Food and beverages, consumer services, media, capital goods and retailing are among the most expensive. Financials could benefit the most from an improvement in Europes ROE. The relative ROE of European banks versus US banks is at a historical low. If each sector in both markets were to return to normalized P/E valuations and ROEs (assuming no change in current book value), European banks would be the biggest beneficiaries relative to their US counterparts, followed by diversified financials and insurance.

Drop in European Bond Yields Should Lead to Better Equity Returns Relative to the US

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Source: FactSet, Morgan Stanley & Co. Research as of June 30, 2013

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

ON THE MARKETS / EQUITIES

Rising Rates Need Not Sink Stocks


MATTHEW RIZZO Head of Investment Strategy & Content Consulting Group Investment Advisor Research Morgan Stanley Wealth Management

any investors believe that financial markets have become too dependent on monetary stimulus from the Federal Reserve and, therefore, any pullback in the central banks Quantitative Easing, which could result in higher long-term interest rates, could damage the economy and the equity market. However, history shows that stocks have generally performed well in rising-rate environments. Much of the concern about rising interest rates has come in the wake of Fed Chairman Ben Bernankes May 22 comments about tapering asset purchases. Remember, though, that interest rates have been rising for more than a year; the yield on the benchmark 10-year US Treasury bond hit a closing low of 1.43% on July 25, 2012. From that date until July 31, 2013, the S&P 500 gained 29% and the MSCI All Country World Index ex US, a broad measure of global equities, rose 25%. In contrast, the Barclays US Aggregate Bond Index fell about 2%. MEASURING RESULTS. To see how equities performed during periods of rising rates, we looked at 13 market indexes, starting with the first quarter of 1980 or as far back as they go (see table). This is essentially the same approach we took in assessing bond performance in periods of rising rates (see Which Bonds Behave Best When Rates Rise? On the Markets, July 2013).

Interestingly, growth stocks, emerging markets (EM) stocks and master limited partnerships (MLPs) performed quite well, although the index data do not go back as far for EM equities and MLPs. Nonetheless, if rates rise for a prolonged period, the implications could be significant for asset allocation and portfolio construction, and we would suggest leaning toward growth stocks, smallcap stocks and the emerging markets. Though EM stocks average quarterly return of 8.78% was by far the best in the past, they were barely positive in the 12 months that ended Aug. 30. CORRELATION WITH EQUITIES. Its also important to remember that not all periods of rising rates are alike. The

absolute level of interest rates can affect their correlation with equity returns. Research from Northern Trust Corp. indicates there is a positive correlation between interest-rate movements and stock returns when the US 10-year Treasury yield is below 5%. With this in mind, we looked at the correlation between rising rates and S&P 500 Index stock returns in periods where the yield was less than 5% going back to 1980, and the correlation was a moderately strong +0.46. Clearly, we still have a long way to go before the 10-year Treasury yield hits 5%. Thus, stocks could continue to perform well, especially if higher rates result from better economic growth, notes Brian Krawez, president and lead portfolio manager at Scharf Investments. Says Krawez, An analysis of the past 140 years shows periods with rising rates have typically been associated with positive future equity returns, driven by improved economic growth.

Equity Index Returns in Periods of Rising Interest Rates

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*Starting with the first quarter of 1980 **Since Dec. 31, 1998, for MSCI Emerging Markets Index; Dec. 31, 1985, for MSCI Mid Cap Growth and Value Indexes, Dec. 31, 1995 for Alerian MLP Index; and since Dec. 31, 1987, for MSCI All Country World Index ex USA. Source: Morningstar Direct, Morgan Stanley Wealth Management CG IAR

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

ON THE MARKETS / FIXED INCOME

Interest Rates Take the Fast Lane


KEVIN FLANAGAN Chief Fixed Income Strategist Morgan Stanley Wealth Management JOHN DILLON Chief Municipal Bond Strategist Morgan Stanley Wealth Management JONATHAN MACKAY Senior Fixed Income Strategist Morgan Stanley Wealth Management

e have been consistently wary of higher intermediate-to-longterm interest rates for 2013, but the swiftness of the recent ascent has been unexpected. We had believed that when the yield on the 10-year US Treasury bond reached 2.75%a two-year highthat the market would take a breather. Instead, the yield blew through that target in mid August and continued to move up, touching 2.90% on Aug. 22 before easing off. Where do we go from here? With interest rate volatility on the rise, developments within the intermediate-to-longer end of the yield curve have become more fluid. As a result, trading ranges have not had the same longevity as in the past. Now, with the 10-year bond within hailing distance of our 3% bear-case scenario, we have raised our operating range by 50 basis points to between 2.50% and 3.25%. TAPERING DELAY? Whether the market continues its climb or takes the breather it missed last month depends on the next jobs report. If the August data come in softer than those of July, we think the market will read it as justification for the Federal Reserve to delay the onset of its tapering policy, which is currently expected to start this

month or next. However, in our view, any delay would be temporary, with tapering likely coming before the end of the year. The starting point for any potential US Treasury relief rally is higher than it was two months ago, and we believe it would stop at the lower end of our new band; during these last two months, the 10-year yield has been below 2.50% only seven times and it hasnt been that low since July 22. While we thought the bond market had largely discounted a September tapering announcement, many market participants link tapering to normalization of the federal funds rate. Although futures markets have heeded Fed Chairman Ben Bernankes words that these two distinctive policy tools are not necessarily linked in the near term, the collective wisdom still holds that, once the federal funds target is raised, the path to normalization will be

quick. This line of thinking appears to be behind the recent move to take the 10-year US Treasury above the 2.75% threshold. Thus, if the Fed is going to push back yet again against market sentiments, it will most likely come in their forward rate guidance language. In the latest Federal Open Market Committee minutes, the Fed did nothing to dissuade the markets base case that tapering would be announced at the conclusion of its Sept. 18 meeting. In order to be pre-emptive, the accompanying policy statement could include some shift in the guidance portion, such as lowering the joblessrate thresholdfor example, from its current 6.5% level down to 6.0%. However, last months minutes did not reveal any hint the policymakers would be taking that approach. FOLLOW THE FUND FLOWS. Credit fund flows have been remarkably resilient, considering the mark-tomarket losses most bond investors experienced in May and June. In fact, we are actually seeing a shift within duration* exposure in fixed income, rather than a shift out of bonds and into

Flows to Investment Grade Funds Slip, Then Recover

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Source: Bloomberg, Investment Company Institute as of Aug. 28, 2013


Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

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equities. According to the Investment Company Institute (ICI), investment grade credit funds had positive inflows nearly every month this year except June, which had only slightly negative outflows (see chart, page 10). As interest rate volatility subsided in July, flows turned positive again, yet the bulk of those inflows have been into short-duration funds, perhaps indicating widespread investor nervousness about rising long-end bond yields. Flows to high yield funds have been a lot more fickle than flows to investment grade funds, with year-todate net flows negative through the end of July, according to ICI. This is due primarily to several weeks of massive outflows in June, which led to the largest monthly outflow ever for the high yield funds. After a small rebound in the first half of July, it appears flows have started trickling out again. INVESTOR SHAKEOUT. We believe the rapid rise in rates accompanied by a widening in credit spreads in the May/June sell-off may have shaken some of the opportunistic tourist money out of the credit markets. The run-up in valuations through the end of April, when the high yield market hit a record-high dollar price and the yield on the investment grade index touched an all-time low, was driven by a search for yield. With interest rates at zero and Quantitative Easing reducing the global net supply of investable assets, many investors were forced into making allocations outside their comfort zones. It may take some additional time for some of these tourist investors to move back out of asset classes like high yield and investment grade credit, but the reallocation process is unlikely to lead to a wholesale rotation out of credit, in our opinion. To weather this rising-rate environment, we suggest investors focus on the middle-risk bands of BBBand BB-rated credits and shorter

Muni and Treasury Yields Work Their Way Higher

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Source: Thomson MMD as of Aug. 29, 2013

durationsthree-to-seven year bonds for investment grade and two-to-seven years for high yield. MUNIS AT HIGHER YIELDS. The current state of relative value and absolute yields in municipal bonds offers a range of actions to investors that are similar to three months ago, but at yields that are substantially higher. Tax-exempts tracked US Treasury rates as they moved higher in May and June (see chart), but unusually heavy summer supply and consistent mutual fund outflows meant greater price deterioration and higher rates for muni bonds. Further US Treasury yield volatility in August compounded the losses. In fact, longer benchmark taxexempt yields increased almost twice as much as corresponding Treasury yields. Despite the elevated yields, the municipal asset class still offers considerable relative value. Accordingly, some investors may wish to add exposure at these higher yield levels, while others may wish to limit duration in their portfolios. In some cases, a combination of the two approaches is also possible.

Going forward, we believe that positioning on both the municipal yield and credit curves will be crucial to portfolio performance as rates continue to rise. As such, we are maintaining our focus on five-to-11-year maturities with 5% or higher coupons; the shape of the yield curve has steepened by nearly 160 basis points year to date, and about 69% of the yield curve is now captured by year 11. In addition, distended spreads on mid-tier A-rated general-obligation bonds and BBB-rated essential-service revenue bonds offer additional yield without extending too far out on the credit curve while the US economy slowly gains strength. On that front, there is evidence of economic improvement: Moodys recently upgraded the credit outlook for the USstates sector to stable after five years of negative outlooks; the Rockefeller Institute reported 13 consecutive quarters of state-level revenue growth; and the S&P/Case-Shiller Home Price Index recently logged 16 straight months of gains in housing prices.

*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.
Please refer to important information, disclosures and qualifications at the end of this material. MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

11

ON THE MARKETS / EMERGING MARKETS

The Great EM Unwind


MANOJ PRADHAN Economist Morgan Stanley & Co.

bubblesuch as credit growth based on assumptions that ultimately prove unsustainablethe impact on growth could be significant. How Will EM Play Out from Here? We believe that one or more, but not necessarily all three, headwinds will play a dominant role at any one point in time over the next 12 to 18 months. Over that period, we expect EM economies to be split into two blocs, good and bad, with a third one where uncertainty hovers: Under pressure. Economies where the growth model is severely challenged China, Brazil and South Africa, and to some degree, Russiaare likely to remain under pressure. Relative winners. Economies where domestic fundamentals are not in question are more likely to benefit. These include Mexico, which is undergoing reform, but also structurally clean economies like Poland and the Philippines. The inbetweeners. Tighter financial conditions have been forced upon some EM economies, particularly Indonesia, India and Turkey. However, they all have something going for them. Indonesia and Turkey do have better domestic fundamentals than many give them credit for, while Indias structural reforms since September 2012 are the reason why we have remained constructive on the medium-term growth story there. Should these three economies play to their respective strengths and avoid policy mistakes, the risk of significant negative spillovers can be abated. India, for example, could step up structural reforms rather than fiscal spending. Indonesia could slow the economy down to lower its current account deficit and undertake structural reforms to strengthen its growth drivers. Finally, Turkey could use its flexible monetary policy mechanism while indicating better control over credit growth, which would lower its current account deficit as well.

hile the US and European stock markets have been enjoying double-digit gains so far this year, the MSCI Emerging Markets Index is facing a double-digit loss. In Brazil and India, two of the big four emerging market (EM) economies, stocks are down more than 20%. Several Asian currencies are under severe pressure as foreign investors look to cash out. Whats going on? Call it the Great EM Unwind. The emerging markets are buffeted by three historical build-ups that are unwinding around the same time: scaling back Quantitative Easing (QE) in the US, deleveraging the Chinese economy and curbing domestic credit growth in many emerging markets. Not all the EM economies are affected equally by all three trends (see chart, page 13). But, in our view, should all three unwind simultaneously, no EM economy would be safe. Brazil, South Africa, Indonesia and perhaps Thailand would be most affected by the combination of these forces. Additionally, external balance sheet risks stemming from higher US real rates and a stronger US dollar will continue to pressure Turkey and India in addition to these four economies. Weaker growth in China will likely have an adverse effect on Taiwan, Korea, Chile and Peru. Finally, credit growth in Thailand will likely be unwound faster than one might have otherwise anticipated. This triple unwind of US QE, Chinas leverage and EM domestic credit would affect EM capital accounts, current

accounts and domestic demand, respectively. For each, there are direct and perhaps indirect spillover effects as well: Unwinding of the US QE hurts EM capital accounts. Recent and future shocks to US real rates and the US dollar raise the risk of a sudden stop of capital flows into EM economies. The direct impact of higher US real rates and the indirect impact of a tightening of financial conditions to protect exposed EM currencies against a stronger US dollar will add to the tightening we have seen so far. Higher real rates could also trigger a faster unwind of credit growth, hurting growth particularly in economies where that credit growth has been excessive. Unwinding Chinas leverage hurts EM current accounts. In the precrisis decade, Chinas re-export model and its strong domestic growth helped to improve EM current accounts. As China deleverages amid a weak export cycle, EM economies stand to export less to China and are therefore likely to see more current account deterioration. The underlying assumption is that China will delever in a reasonably stable manner. A rapid deleveraging could unsettle not just the EM world but the global economy as well. Weaker current accounts could result in further negative spillovers. First, they will require more financing. Weaker current accounts may force real rates higher as savings fall relative to investment. Higher real rates could slow down credit and economic growth. Unwinding EM domestic credit growth hurts economic growth directly. Not all bubbles hurt economic growth, but when growth is accompanied by a credit

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

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The great EM unwind is putting economies through a tricky phase. While many policymakers are talking about structural reforms, the ability or willingness to deliver on such reforms is in

shorter supply. The rigidities and unsustainable models of growth that are constraining emerging markets are the very source of their promise. Should these rigidities and unsustainable models be

discarded, emerging markets can again convincingly outperform in terms of growth. Unfortunately, a return to the glory days seems some distance away at the moment.

How the Unwinding Trends May Affect Emerging Economies

Source: Morgan Stanley & Co. Research

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

13

ON THE MARKETS / Q&A

Living With the New Normal


ne of the frustrations for policymakers, politicians and investors in recent years is just how long it has taken for the US and global economies to recover from the Great Recession. Investment management firm PIMCO calls this sluggish economic growth the New Normal. In this interview with Mike Wilson, Morgan Stanleys chief investment officer and chair of the Global Investment Committee, PIMCO CEO and Co-CIO Mohamed El-Erian speaks about todays market and economic trends and looks down the road at fixed income and the emerging markets. The following is an edited version of their conversation.
MIKE WILSON (MW): PIMCO has talked about the New Normal for years. How much longer can we expect growth to remain below trend? What major regions around the world are most likely to surprise on the up and down sides over the next couple of years? MOHAMED EL-ERIAN (ME): The New Normal was a relatively simple concept for us, to signal that unusual things were going to happen: growth would be unusually sluggish for a while in the Western economies, unemployment would be high, there would be more regulation and a bit of deglobalization and emerging markets would do relatively better economicallyeven though conventional wisdom had them in the hospital. Every one of these things has happened. The New Normal trends were based on the observation that the 2008 crisis was more than a cyclical shockit was also a secular and a structural change, with political and policy consequences.

Politicians would not choose the New Normal because they have less to give away and must make difficult decisions taking pain up front for later gainso the risks of political paralysis go up, which is what weve seen. The one policymaking entity immune from political paralysis is the central bank, which has autonomy and can act. So the New Normal has led to two things impacting markets: political polarization and dysfunction, and the central banks playing an important role, albeit on the basis of imperfect instruments and experimental policy. Over the next three to five years, were looking at a three-speed global economy. The faster speed will remain the emerging worldslowing cyclically but still capable of a 5% to 6% growth rate. The middle speed will be the US growing at about 2% in real termsout of the hospital and walking briskly but still too structurally impaired to achieve escape velocity in the 3%-to-3.5% range. The lower speeds will be Europe and Japan, because of deeply embedded structural issues in the system, not just lacking growth but with no growth engines, and needing to completely recast their economic model. Looking forward, there are two very clear tails that one has to make judgments on when constructing asset allocation. The first is political dysfunction paralyzing the economy. If youth unemployment stays at 24% for Europe as a whole and at 56% for Spain and 59% for Greece, the likelihood of something bad happening goes up; the politicians lose control and you have a disruptive element. Similarly, if China cannot handle its middle-income transition, its growth engine will slow down.

A couple of things on the other side have significant upside potential. One is innovation, particularly in energy, digital and 3-D technology. These are transformational, sectoral in impact but they could get to be macro. Second, if our politicians can get to what we call a Sputnik momentmerging our national purpose and visionyou can unlock growth pretty quickly. MW: In May and June, we saw the biggest selloff in rates since 2003. Is the US finally reaching escape velocity or is it just a short-term move in rates? ME: I wish for escape velocity, but were not there yet. What happened in May and June had more to do with concern that the Fed would no longer be there. On May 22, when talk of Fed tapering came up, then again on June 19, when the minutes were released, the markets overreacted and started pricing terminal values and not a journey, which is what the Fed wants. Thats why you saw this attack on all forms of carry, and the equity market sold off. The central bankers got scared, and there was an orchestrated attempt to walk back from this talk. You also had different ways of normalization. Weve almost fully normalized risk spreads but hardly interest rate spreads. Why? First, because the economies did strengthen, economic data surprised; it wasnt an escape-velocity world, but it was confirmation of gradual healingwhich favored risk assets over interest rate spreads. Second was the technical positions: There had been such a massive move into fixed income, including Treasuries, that you had a reallocation. The technicals favored risk assets more than they did interest rate spreads. Compared to May 19, the world today doesnt look much different for risk assets, but it does for interest rate spreads because this notion of Fed tapering means less of a Fed push for interest rate markets. MW: When do you think the tapering and rate hikes will begin? The consensus

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

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is September to October for tapering and 2015 for rate hikes. ME: We agree with the consensus for tapers but not for rate hikes. There are three measures now in place: (1) interest rates floored basically at zero; (2) very aggressive forward-guidance policy linked to unemployment levels of 7.0% and 6.5%; (3) Quantitative Easing (QE) of $85 billion a month. Sequencing is important; our sequence is that Stage 1 is tapering the purchasesmaybe going to $70 billion or $65 billion. We think theres a 75% or 80% probability that could happen as early as September or October. However, the reason for tapering is important. Is it for positive reasons or both positive and negative reasons? You taper for positive reasons when the economy takes off and you achieve escape velocity, which we are not. The reason theyre going to taper is because, in addition to growth being somewhat stronger, they are worried about the cost and risks of prolonged reliance on experimental monetary policywhat we call the collateral damage and unintended consequences. Therefore, when they taper, they will probably maintain very strong forward-guidance policy, or even strengthen it. MW: In January, were getting a new Fed chairman. Whats your view on who might get the post and what that means? ME: Both [Fed Vice Chairman] Janet Yellen and [former US Treasury Secretary] Larry Summers are qualified, with significant policy experience. They both have made a transition and have passion in applying expertise and economic training to real-life issues. But they have different styles. Yellen is better known to the market; she would be a continuation of Bernanke. The market knows Summers views on fiscal policy and much less about his views on monetary policy. So the uncertainty premium at the initial stage is slightly higher with Summers. But the longer this decision takes, the more potential damage. Looking at fiscal policy, governments have direct tools to

force you to do thingspay taxes, spend a certain way. Central banks have indirect tools. Whether its forward guidance, controlling part of the yield curve, or QE, theyre trying to convince us to do the heavy lifting. When you rely on indirect tools, the credibility of a central bank becomes very important; look at the time before former Fed Chairman Paul Volker, when the central bank had virtually no credibility and had difficulty convincing the private sector to do anything. The best thing for the market is for the decision to be made quickly. But dont underestimate the possibility of [former US Treasury Secretary] Timothy Geithner as a third candidate, even though he said he doesnt want to move back to DC. MW: Looking at fixed income allocations, what types of strategies are you looking to implement going forward? ME: There are two beta anomalies in todays fixed income markets: munis and emerging market debt. With munis, if you look at the ratios of nontaxables to taxables, they are at high levels for a good reason. Detroit has shaken a lot of people, and that whole sector is trading creepy right now. Many people assumed that munis were simply interest rate risks, not realizing there could be credit and even default risks. We see opportunity high up in the capital structure and in the strong balance sheet general-obligation bonds, especially for people who can take advantage of a tax break. We also think theres valueand its a risk spread in fixed incomein emerging markets, because of the technicals. As an asset class, emerging markets have a relatively low and dedicated investor base and a very high crossover investor base. Crossover investors are those who invested as an off-benchmarkwhen its hot, its really hot. But the minute there are question marks, you get a very strong technical reaction because all the money flows out. We call it tourist dollars. MW: The view that emerging market economies should grow faster hasnt translated into profitabilitymaybe because the benchmarks are somewhat

skewed to certain countries or sectors. What are your thoughts on investing in emerging market equities away from the benchmark? ME: I wish we could replace the emerging markets label. It was a great shortcut when emerging markets were homogeneous, but now we have an enormous amount of diversity. There are certain developed economies that look more like emerging economies. Certain emerging economies behave and are much more like developed economies. If youre going to invest in emerging markets, recognize that youre underwriting the technical risks I mentionedits going to overshoot on one side when everybody loves it, and overshoot on the other side when all the crossover investors get out. Youve got to scale it in such a way that you can absorb that volatility. Make sure you dont simply buy [a product that tracks] the index, because the index has a tendency to allocate too much to countries more likely to have problems. Its better to be a country selector than to buy a [product that tracks a] passive index in an emerging market. As for their relative underperformance, they became too popular. A lot of people came into the asset class and took the liquidated premiums really low, almost to a negative. In addition, many people oversaw the growth story. Many companies that gained from the growth stories are not ones you can buy in an indexits a very different story today. A strategy we would suggest is to start with using the overweight of the US vs. the emerging markets; its a trade that has worked well. But if you look at valuations and at prospects, its hard to see that amount of outperformance continuing going forward. Mohamed El-Erian is not an employee of Morgan Stanley Wealth Management. Opinions expressed by him are solely his own and may not necessarily reflect those of Morgan Stanley Wealth Management or its affiliates.

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

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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
5% High Yield 1% Inflation-Linked Securities 5% Emerging Markets Fixed Income 3% Diversified Commodities 2% REITs 3% Emerging Markets Fixed Income 4% High Yield

MODEL 2
5% Hedged Strategies 1% Managed Futures 17% Cash 42% Investment Grade Fixed Income 5% Diversified Commodities 2% REITs 8% US Equity 10% International Equity 5% Emerging Markets Equity 3% Emerging Markets Fixed Income 3% High Yield

MODEL 3
7% Hedged Strategies 2% Managed Futures 12% Cash 12% US Equity 33% Investment Grade Fixed Income 13% International Equity 8% Emerging Markets Equity

32% Cash

57% Investment Grade Fixed Income

MODERATE

MODEL 4
6% Diversified Commodities 3% REITs 2% Emerging Markets Fixed Income 2% High Yield 26% Investment Grade Fixed Income 10% Emerging Markets Equity 8% Cash 15% US Equity 17% International Equity 9% Hedged Strategies 2% Managed Futures
7% Diversified Commodities 3% REITs 1% Emerging Markets Fixed Income 1% High Yield 17% Investment Grade Fixed Income

MODEL 5
10% Hedged Strategies 2% Managed Futures 7% Cash
18% US Equity

MODEL 6
8% Diversified Commodities 3% REITs 1% Emerging Markets Fixed Income 22% US Equity 25% International Equity 11% Hedged Strategies 2% Managed Futures 6% Cash

21% International Equity

13% Emerging Markets Equity

7% Investment Grade Fixed Income 15% Emerging Markets Equity

AGGRESSIVE

MODEL 7
11% Hedged Strategies 8% Diversified Commodities 25% US Equity 3% Managed Futures 5% Cash 11% Hedged Strategies 8% Diversified Commodities

MODEL 8
3% Managed Futures 5% Cash

KEY

19% US Equity 3% REITs 20% Emerging Markets Equity 31% International Equity

CASH GLOBAL FIXED INCOME GLOBAL EQUITIES ALTERNATIVE INVESTMENTS

3% REITs 17% Emerging Markets Equity

28% International Equity

Note: Hedged strategies consist of hedge funds and managed futures.

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

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Tactical Asset Allocation Reasoning


Relative Weight Within Equities Underweight We have been slightly underweight since March, expecting a correction as markets adjust to less stimulus from the Federal Reserve and higher interest rates. We believe the correction is approximately 50% complete and investors should be looking to add US equity risk over the next few weeks/months. We increased our exposure to Japan and Europe in March. Meaningful political change has taken place in Japan, leading to significant currency depreciation, which is typically bullish for equity prices. Economic growth and structural issues remain in Europe, but they are well known and priced in. Recently, economic growth has picked up, which should lead to accelerating earnings growth and better stock performance. Emerging markets have been far and away the most disappointing this year. Policy remains too tight in several regions, both voluntarily (as in China) and involuntarily (as in India and Brazil). Nevertheless, structural challenges will likely keep policy tight in the near term, so we believe that the emerging markets will be slow to recover recent losses.

Global Equities
US

International Equities (Developed Markets)

Equal Weight

Emerging Markets

Equal Weight

Global Fixed Income


US Investment Grade

Relative Weight Within Fixed Income Overweight We recommend investors hold shorter-duration (maturities) given potential capital-loss risks associated with the current low yields. Yields have risen recently, but not enough for us to advocate a shift away from our shorter-duration strategy. Within investment grade, we prefer BBB-rated corporates and securitized debt to Treasuries. Yields are low globally so not much additional value accrues to owning international bonds beyond some diversification benefit. We have been underweight inflation-linked bonds since March given negative real yields across the yield curve. Recently these yields have turned modestly positive for 10-year maturities but still dont offer enough compensation, especially since these securities are longer duration than Treasuries. Yields remain near record lows but have improved recently. Opportunity has arisen given the indiscriminate selling that has occurred. Investors can begin to wade back in selectively to high yield credits via active managers or single issues. We reduced our weighting to equal weight from overweight in March given record-low spreads and yields. Despite the sharp correction since then, we recommend further patience given the heightened structural issues faced by the emerging markets.

International Investment Grade

Equal Weight

Inflation-Linked Securities

Underweight

High Yield

Underweight

Emerging Market Bonds

Equal Weight

Alternative Investments
REITs

Relative Weight Within Alternative Investments Equal Weight Rising interest rates explain most of the recent sharp correction. At current levels, we think REITs are fairly valued and ofter some selective opportunities. Commodities have suffered over the past quarter as real interest rates went up; China maintained tight monetary and fiscal policies; and the US dollar strengthened. Recently, sentiment has improved due to rising geopolitical risks and economic stabilization in China.

Commodities

Equal Weight

Hedged Strategies (Hedge Funds and Managed Futures)

Equal Weight

This asset class can provide uncorrelated exposure to other risk-asset markets. It tends to work well in more challenging financial market conditions such as the current environment.

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

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ON THE MARKETS

Index Definitions
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. TOPIX INDEX Also known as the Tokyo Stock Price Index, the TOPIX is a capitalizationweighted index of all companies listed on the First Section of the Tokyo Stock Exchange. MSCI EUROPE INDEX This free-float-adjusted capitalization-weighted index is designed to measure the performance of 16 developed European markets. MSCI ASIA PACIFIC EX JAPAN This free-float adjusted capitalization-weighted index is designed to measure the performance of equities in Australia, Hong Kong, New Zealand and Singapore. MSCI USA INDEX This index is designed to measure the performance of the large- and midcap segments of the US equity market. With 586 constituents, the index covers approximately 84% of the free float-adjusted market capitalization in the US. MSCI ALL COUNTRY WORLD INDEX This is a free-float-adjusted, market-capitalizationweighted index that is designed to measure the equity market performance of 24 developed and 21 emerging markets. BARCLAYS AGGREGATE BOND INDEX This RUSSELL 2000 VALUE INDEX This

index measures the performance of small-cap value segment of the US equity universe. It includes those Russell 2000 Index companies with lower price/book ratios and lower forecasted growth values.

RUSSELL MID CAP VALUE INDEX This

index measures the performance of the mid-cap value segment of the US equity universe. It includes those Russell Midcap Index companies with lower price/book ratios and lower forecasted growth values.

index provides a broad-based measure of investment grade government/credit and the mortgage-backed sectors of the bond market. This index is rebalanced monthly by market capitalization.
RUSSELL MIDCAP INDEX This index

MSCI Emerging Markets Index is a free-float-adjusted market-capitalization index that is designed to measure equity market performance in the global emerging markets.
RUSSELL 2000 INDEX

MSCI EMERGING MARKETS INDEX The

measures the performance of the mid-cap segment of the US equity universe. It includes approximately 800 securities based on market capitalization and represents approximately 31% of the US equity market. index is a composite of the 50 most prominent energy master limited partnerships (MLPs) that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index is calculated using a float-adjusted, capitalization-weighted methodology.

RUSSELL 2000 GROWTH INDEX This index measures the performance of the small-cap growth segment of the US equity universe. It includes those Russell 2000 Index companies with higher price/book ratios and higher forecasted growth values. RUSSELL 1000 INDEX This

index measures the performance of the large-cap segment of the US equity universe. It represents approximately 92% of the US market.

This index measures the performance of the 2,000 smallest companies in the US equity market. index includes approximately 50 of the largest US securities based on their market capitalization.

ALERIAN MLP INDEX This

RUSSELL 1000 GROWTH INDEX This index measures the performance of the Russell 1000 companies with higher price/book ratios and higher forecast growth rates. RUSSELL 1000 VALUE INDEX This index measures performance of the Russell 1000 companies with lower price/book ratios and lower forecast growth rates. FTSE NAREIT US REAL ESTATE INDEX

RUSSELL TOP 50 INDEX This

This index offers exposure to US investment and property sectors.

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

18

ON THE MARKETS

Risk Considerations
MLPs
Master Limited Partnerships (MLPs) are limited partnerships or limited liability companies that are taxed as partnerships and whose interests (limited partnership units or limited liability company units) are traded on securities exchanges like shares of common stock. Currently, most MLPs operate in the energy, natural resources or real estate sectors. Investments in MLP interests are subject to the risks generally applicable to companies in the energy and natural resources sectors, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

Disclosures
Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investors 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.

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

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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 investors 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. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bonds 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. 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. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Stocks of medium-sized companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies. 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. 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.

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

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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. Principal is returned on a monthly basis over the life of a mortgage-backed security. Principal prepayment can significantly affect the monthly income stream and the maturity of any type of MBS, including standard MBS, CMOs and Lottery Bonds. Yields and average lives are estimated based on prepayment assumptions and are subject to change based on actual prepayment of the mortgages in the underlying pools. The level of predictability of an MBS/CMOs average life, and its market price, depends on the type of MBS/CMO class purchased and interest rate movements. In general, as interest rates fall, prepayment speeds are likely to increase, thus shortening the MBS/CMOs average life and likely causing its market price to rise. Conversely, as interest rates rise, prepayment speeds are likely to decrease, thus lengthening average life and likely causing the MBS/CMOs market price to fall. Some MBS/CMOs may have original issue discount (OID). OID occurs if the MBS/CMOs original issue price is below its stated redemption price at maturity, and results in imputed interest that must be reported annually for tax purposes, resulting in a tax liability even though interest was not received. Investors are urged to consult their tax advisors for more information. Credit ratings are subject to change. Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom. Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, sale, exercise of rights or performance of obligations under any securities/instruments transaction. This material is disseminated in Australia to retail clients within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813). Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the research in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities. Morgan Stanley Private Wealth Management Ltd, authorized by the Prudential Regulatory Authority and regulated by the Financial Conduct Authority and the Prudential Regulatory Authority, approves for the purpose of section 21 of the Financial Services and Markets Act 2000, research for distribution in the United Kingdom. Morgan Stanley Wealth Management is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. Morgan Stanley Wealth Management research, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC. 2013 Morgan Stanley Smith Barney LLC. Member SIPC.

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

MORGAN STANLEY WEALTH MANAGEMENT | SEPTEMBER 2013

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