gic changes

global investment committee

march 8, 2013

Global Investment Committee Strategic and Tactical Asset Allocation Changeanalysis authors

Moving Toward a Barbell Approach ueprimarilytoourassumptionforsome D interestratenormalizationoverthenext sevenyears,weareincreasingourStrategic allocationtoequitiesattheexpenseoffixed income,whilekeepingcashandalternative allocationsroughlythesame. Werecommendamodifiedbarbellapproach thatfavorsshorter-durationfixedincome (onetofiveyears),cashandequitieswhile de-emphasizingintermediate-andlong-term fixedincomesecurities. Withinequities,werecommendashifttowardinternationalequitiesincludingJapan, Europeandemergingmarkets.TheUShas ledtheglobalrecovery,butnowotherequity marketsappeartooffersimilarormoreupside whileprovidinggreaterdiversification. Withinalternatives,werecommendamove fromhedgedstrategiestocommodities. Tactically,werecommendonlyapartialshift towardourhigherequityweightingsaswe seektobeopportunisticwiththereallocation. Wehavechangedourstrategichorizonto sevenyearsfrom20yearsbecausewebelieveitismorepracticalformostinvestors. Inaddition,wenowhaverecommendations foronlytwowealthlevels,with$25million beingthebreakpoint.

michael wilson

Chief Investment Officer Morgan Stanley Wealth Management

david m. darst, cfa

Chief Investment Strategist Morgan Stanley Wealth Management

martin l. leibowitz

Global Research Strategy Morgan Stanley & Co.

Strategic Changes for Broad Asset CategoriesCategory Cash Global Equities Global Fixed Income Global Alternatives Decrease No Change Increase

adam s. parker

Chief US Equity Strategist Morgan Stanley & Co.

andrew slimmon

Head of Applied Equity Investors Morgan Stanley Wealth Management

Follow us on Twitter @MSWM_GIC

Morgan Stanley Wealth Management Global Investment Committee as of March 8, 2013

strategic and tactical asset allocation change / global investment committee

Asmanyofyouknow,werecentlyformed anewGlobalInvestmentCommittee (GIC).Ourprimaryfunctionremains toproviderecommendationsforasset allocationonbothastrategicandtacticalbasis.However,wehaverevised someoftheparametersunderwhich weoperate.First,wehaveshiftedour strategictimehorizonfrom20yearsto sevenyearsbecausewebelievethatitis amorepracticallong-terminvestment horizonformostinvestors.Whatsmore, mostmarketstendtomeanrevertover sevenratherthan20years.Second,we nowonlyproviderecommendationsfor twowealthlevelsinsteadofthree,with $25millionbeingthebreakpoint. Todaywearemakingsomechanges toourrecommendationsbasedonour fundamentalanalysisandtherelative attractivenessoftheassetcategories. Duetotodaysunusualenvironment,a

majorfactorofassetallocationremains central-bankactivityanditsimpacton markets.Inmakingourrecommendations,weassumesomepolicyand interestratenormalizationduringthe strategictimehorizon.Thisassumptionhasameaningfulimpactonour strategicrecommendations. Whilemuchhashappenedsincethe financialcrisisandtheGreatRecession of2008-2009,suchoutcomeswerenot unprecedented.Infact,marketsmight bebehavingasexpectedgiventheevents andreactionbypolicymakers.Equity marketstendtoexhibitaverydistinct patternofperformancefollowingsuch financialcrises,andthistimeisnodifferent(seePositioning,Feb.28,2013). Specifically,equitymarketsrallysharply fromtheiroversoldconditionandthen tradeinawiderangeforalongperiod oftime.Sincethiswasaglobalfinancial

crisis,virtuallyeveryfinancialmarket aroundtheworldhasbeenaffected. However,globalmarketsrecoveries havevariedwidelymainlybecauseof policiesenactedandhowcompanieshave respondedtothem.Towit,theUSequity markethasledthedevelopedandmuch oftheundevelopedmarketssincethe lowsofthecrisis(seeFigure1).There aremanyreasonsforthis,butthemost importantdriveristhattheearningsrecoveryhasbeenstrongerintheUSthan inotherregions. USfixedincomeassetshavealsoperformedquitewelloverthisperiod,which issurprisinggiventherelativelystronger growth.Thiscanbeattributedtotwothings: theFederalReservesmassiveinterventionintheUSfixedincomemarkets;and theobservationthatearningsgrowthhas beenmuchbetterthaneconomicgrowth, thekeydriverforinterestrates.Earnings

Figure 1: Major Market Returns Since the Cyclical LowsAsset Category Equity large-Cap Growth large-Cap Value Mid-Cap Growth Mid-Cap Value Small-Cap Growth Small-Cap Value Europe Japan Equity Asia Pacific ex Japan Equity Emerging Markets Equity Fixed Income US Fixed Income International Fixed Income Inflation-linked Securities High yield Emerging Market Fixed Income Alternative Investments rEIts Commodities Hedged StrategiesSource: FactSet as of Feb. 22, 2013

US equities have generally outpaced non-US equities, both in US dollars and local currencies, since the markets bottomed in late 2008 and early 2009. us dollar 137% 139 192 203 198 222 113 59 194 165 35 28 60 147 95 219 35 19 Total Return Since Cyclical Low date local currency 3/9/09 3/5/09 11/20/08 3/9/09 3/9/09 3/9/09 3/9/09 3/10/09 3/9/09 10/27/08 10/31/08 6/13/08 11/21/08 11/24/08 10/27/08 3/9/09 3/2/09 1/21/09 137% 139 192 203 198 222 94 51 106 137 35 32 54 147 76 207 35 19 date 3/9/09 3/5/09 11/20/08 3/9/09 3/9/09 3/9/09 3/9/09 3/12/09 3/9/09 10/27/08 10/31/08 10/28/08 11/24/08 11/24/08 10/27/08 03/09/09 03/02/09 01/21/09

Representative Index

MSCI US large Cap Growth MSCI US large Cap Value MSCI US Mid Growth MSCI US Mid Value MSCI US Small Growth MSCI US Small Value MSCI Europe MSCI Japan MSCI Pacific ex Japan MSCI Emerging Markets IMI BC US Aggregate Bond BC Global Aggregate ex US (hedged) BC Universal Inflation-linked (unhedged) BC Global High yield (hedged) JP Morgan Emerging Markets (unhedged) FtSE EPrA/nArEIt Global Dow Jones-UBS Commodity HFrI Fund of Funds

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

MorGAn StAnlEy

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march 8, 2013

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strategic and tactical asset allocation change / global investment committee

growthhasoutpacedeconomicgrowth becausecompanieshaverespondedtothe environmentwithfrugalityespecially withhiring.Thisimpliesthatbondsand stocksmightbetradingabovewherethey wouldbewithoutgovernmentintervention,especiallyintheUS.

Figure 2: Estimating Strategic Equity ReturnsStrategic Strategic 10-yr. Govt. Cash Return Bond Return US Canada UK Euro Zone Japan Australia Emerging Markets 1.1% 1.6 1.7 1.0 0.7 3.4 n/A 1.1% 0.9 1.4 2.5 0.4 2.6 4.8

To determine a strategic equity return, we start with the 10-year government bond return and add in the equity risk premium and the valuation adjustment.

Equity Risk Premium 4.2% 4.2 4.2 4.2 4.2 4.2 4.2

Valuation Strategic Adjustment Equity Return -1.0% -0.9 0.2 0.8 0.7 -2.4 0.1 4.3% 4.2 5.8 7.5 5.3 4.4 9.1

Followingintensiveanalysisanddiscussion,wehaverecentlyupdatedourannual returnforecastsforallofthemajorequity andfixedincomemarkets(seeFigure2). Theforecastsaresignificantlydifferent thanlastyears(seeStrategic Asset Allocation: Annual Update of Capital Market Assumptions,March2013)Thesereturn forecastsaffectourstrategicassetallocationsattheboththebroadassetcategory andregionallevels.Fromtheseforecasts, wesurmisedthatcashmightbeabetter placetobethanbonds,assumingsome degreeofinterest-ratenormalization overthenextsevenyears.Thatmayrepresentanewinsightformanywhohave assumedthatcashistrashinaworld offinancialrepressionandnegativereal rates.Tobeclear,cashwilllikelyhave negativerealreturns,too,butwithmuch lessriskthanbonds. Anotherimportantimplicationof ouranalysisisthatabnormallylowreturnsinbondsdonotnecessarilymean thatreturnsinequitiesarelikelytobe higherthannormal.Infact,wethink returnsarelikelytobelowerthannormal acrosstheentirecapitalstructureover theseven-yearstrategichorizon.Such isthecostofthemonetarypoliciesthat havebeenpursuedtoeasethepainof deleveraging.Ofcourse,thissaysnothingaboutthereturnsinanygivenyear, whichcouldbemeaningfullyaboveor belowtheexpectedstrategicreturns. The end result is that on a strategic basis, we have decided to increase our allocation to equities at the expense of fixed income, keeping cash and alternative allocations roughly the same. WhilethisappearstoreflectaGreat Rotationmove,wewanttoemphasize thatweexpectreturnstobeloweracross thecapitalstructureonastrategicbasis(sevenyears)andinlinewithour

Rethinking the Future

Source: thomson reuters, oECD, Consensus Economics, Morgan Stanley Smith Barney as Dec. 31, 2012

forecasts.Infact,ifratesnormalizefully ormorequicklythanweassume,many fixedincomeinvestmentscouldproduce negativenominalreturns,something manyinvestorsarenotpreparedtoaccept. Inadditiontotheshifttowardequitiesfromfixedincome,wehavetwo othersignificantchangesinthestrategic allocations:Withinfixedincome,we arenowemphasizingshorter-duration securities(onetofiveyears)thanpreviously.Thisalsofitswithourforecast forratenormalizationoverthenext sevenyearsandrepresentsabarbell approach(morecash,short-duration fixedincomeandequities,andlesslong durationfixedincome).Thispositioning affordsustheopportunitytobemore tacticalwithequitiesandalternatives whileseekingtoaddperformanceto ourlowexpectedpassivereturns.Italso helpstohedgeagainstthemovetoward higherinterestratesthatweanticipate duringthenextsevenyears. Wearealsoshiftingourstrategicequity allocationstowardinternationalmarkets. Muchofthismovereflectsourstrategic returnforecasts,combinedwithassumptionsabouttherelativeratesofchange ofgrowthandpolicybetweenregions. BecausetheUShasledtheglobalrecovery,returnshavebeenbetter.Thatalso explainswhyequityvaluationsarehigher intheUSandsomightofferlessreturn potentialoverthestrategictimehorizon. Somewilldisagreewiththislogic,butthe

empiricaldataunderlyingourstrategic returnforecastsarequitecompelling.Whats more,AdamParker,MorganStanleys chiefUSequitystrategist,hasdoneextensiveanalysisthatclearlyillustrates UScompaniesarecurrentl