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