June 22, 2012 GLOBAL CROSS-ASSET STRATEGY

Global Debates Playbook Policy Grade: Incomplete Policy shortcomings in Europe and in the US have amplified downside risks, reinforcing our cautious view. Extending Operation Twist six months effectively tied the Fed's hands to a policy with low benefit. It leaves markets more vulnerable to negative growth data or stress in Europe because additional Fed action is unlikely. Removing the central bank ‘put’, unless conditions deteriorate significantly, actually increases the risk of a bigger correction. The situation in Europe is likely to get worse before it gets better. The nearterm tail risk of Greece leaving the euro is lower, but the economy is still depressed. Spanish bank recaps could provide a temporary reprieve, but only if the funding is not through the government. Markets are likely to be skeptical of any policy response that doesn't lay out a plan for a banking and fiscal union, with a Europe Redemption Fund as a possible intermediate step. We do not expect such a policy announcement at the EU Summit on June 28/29.

Asset Class Views (3-6 months)

MORGAN STANLEY RESEARCH

USD

Global Cross-Asset Strategy Group

JPY

Morgan Stanley & Co. Incorporated

US Credit

Gregory Peters 

EM Rates

+1 212 761-1488

US Treasuries

Morgan Stanley & Co. International plc. +

Europe Credit

Neil McLeish 

–

EM Equities EM Currencies German Bunds EM Credit US Equities Europe Equities

Markets have been pricing out tail risks and risk sentiment has moved to neutral. Volatility across asset classes is down after the Greek election. With increased downside risks and lower volatility, putting tail hedges back on is attractive, in our view.

Commodities

We continue to prefer safe haven assets. Growth and eurozone risks should continue to weigh on higher beta. Though EM markets have stabilized, the economies remain vulnerable to problems in DM. Bunds should retain their safety status, but positive developments in Europe would be negative for them.

Oil

Japan Equities GBP

EUR

+

+44 (0)20 7677 7481

Morgan Stanley Australia Ltd. +

Gerard Minack  +61 2 9770 1529

Morgan Stanley & Co. Incorporated

Jason Draho  +1 212 761-7893

Please see page 2 for full list of members

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Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Table of Contents Global Cross-Asset Strategy Global Cross-Asset Strategy Overview Market Commentary Risk-Reward Views: Economics Global Economics US Europe Japan China Asia ex-Japan Brazil / Latam India Russia Risk-Reward Views: Strategy US Rates Europe Rates UK Rates EM Fixed Income G10 Currency EM Currency US Equities Europe Equities Japan Equities Asia / GEMs Equities US Corporate Credit Europe Corporate Credit Asia Corporate Credit Securitized Credit Global Credit Derivatives Crude Oil Cross-Asset Volatility

Global Cross-Asset Strategy Group 3 4 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45

Economics Joachim Fels2 Vincent Reinhart1 David Greenlaw1 Elga Bartsch2 Robert Feldman5 Takehiro Sato5 Helen Qiao3 Chetan Ahya3 Gray Newman1 Tevfik Aksoy2 Manoj Pradhan2

+44 (0)20 7425 6138 +1 212 761 3537 +1 212 761 7157 +44 (0)20 7425 5434 +81 3 5424 5285 +81 3 5424 5367 +852 2848 6511 +852 2239 7812 +1 212 761 6510 +44 (0)20 7677-6917 +44 (0)20 7425-3805

Strategy Greg Peters1 Neil McLeish2+ Gerard Minack4+ Jason Draho1 Laurence Mutkin2+ Hans Redeker2+ Gabriel de Kock1 Adam Parker1 Graham Secker2+ Jonathan Garner3+ Rizwan Hussain1 Adam Richmond1 Andrew Sheets2+ Viktor Hjort3+ Vishy Tirupattur1 Sivan Mahadevan1 Hussein Allidina1 Yohei Yamada5

+1 212 761-1488 +44 (0)20 7677 7481 +612 9770 1529 +1 212 761-7893 +44 (0)20 7677 4029 +44 (0)20 7425 2430 +1 212 761-5154 +1 212 761-1755 +44 (0)20 7425 6188 +852 2848 7288 +1 212 761-1494 +1 212 761-1485 +44 (0)20 7677 2905 +852 2848 7479 +1 212 761 1043 +1 212 761 1349 +1 212 761 4150 +81 3 5424 5923

1 Morgan Stanley & Co. LLC 2 Morgan Stanley & Co. International plc 3 Morgan Stanley Asia Limited 4 Morgan Stanley Australia Ltd 5 Morgan Stanley MUFG Securities + Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

2

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Global Cross-Asset Strategy: Base Case Overview From a long-term strategic perspective, we are bearish on developed market equities, while bullish on emerging market assets. DM is in a multi-year deleveraging cycle fraught with numerous negative feedback loops, and faces a long, difficult road to economic recovery as a result. In contrast, the strong secular fundamentals for EM economies should continue. Our base case is slowing global growth, and divergence between anemic DM and solid EM. Our economists forecast global growth of 3.7% in 2012, with EM at 6.1% and DM at 1.3%. European recession is our base case; US and EM recession is in the bear scenario. Risks are to the downside on constrained policy and potential fiscal tightening. Sovereign risk in the eurozone will remain elevated until there is tangible progress towards banking and fiscal unions. The Greece election reduces the near-term tail risk of a euro exit, but a ‘Euro Divorce’ is still a decent probably over the next 12-18 months. A Europe Redemption Fund could serve as a bridge to the fiscal union. The EM outlook should improve in 2H12, with increased regional differentiation. Growth remains moderate, but policy easing should improve the outlook by 2H12. China is key; a soft landing still looks likely, and increased stimulus is likely to help growth pick up starting in 2Q12. Stay nimble on binary risks skewed to the downside and high volatility. With policy and politics still dominant, markets are likely to remain tactically oriented and range-bound.

Asset Class Views (3-6 months) We believe the risk-reward skew is worse than the market expects. The combination of slowing global growth, eurozone risks, and insufficient policy responses leaves risk assets vulnerable to larger corrections. Regionally, the US continues to look the strongest on a tactical basis. This is a relative not absolute call on the US; a number of potential potholes lie ahead in 2H12 that could lead to more weakness. EM markets have stabilized, but we would wait for signs that policy stimulus in China is having a noticeable effect, and that funding and deleveraging stress related to Europe are contained. Credit still on top. Valuations are not overly compelling on an absolute basis but in a slower growth environment credit can do well, especially relative to equities. Europe credit is cheaper than the US and fundamentals are solid, but without a catalyst we will continue to prefer the US. Seeking lower beta in equities. Within DM, better growth and lower risks in the US relative to Europe are enough to offset more expensive valuations. AxJ equities are cheap, but we continue to wait for more substantive stimulus from China. Neutral on Treasuries, a bit bearish on Bunds. Flight-to-safety bids should keep yields low for both. While Bunds should retain safe haven status, positive developments in Europe could reduce that bid. Bullish on USD, bearish EUR. Safe haven status supports the USD, and without QE3 downside risk. Short-term capital flows and limited room for JGB yields to fall should help JPY outperformance. EM currencies have stabilized, but remain at risk to funding market stress. Caution on commodities. We see still more downside risk to commodities, as EM growth weakness is negative for more economically sensitive metals. A stronger USD also works against commodities.

Risk Factors / Catalysts • Political uncertainty in Greece. The formation and composition of a new government has yet to be formalized; we don’t yet know to what extent the bailout program can be renegotiated.  Spain deteriorates. Economic contraction accelerates, fiscal targets are missed, the bank bailout plan further strains Spanish public finances and subordination concerns deter private investors.  China hard landing. Growth fails to pick up because of an external slowdown and lack of policy flexibility to respond sufficiently to spur growth.  Deleveraging is disorderly. If deleveraging occurs too quickly, markets could destabilize. If it’s too slow, markets could destabilize as debt levels stay high.  Political election cycles. US election and the fiscal cliff lead to ineffective or counter-productive fiscal policies.  Upside risk: Coordinated global monetary policy as central banks jointly ease.  Upside risk: Policy break-through in Europe on moving toward fiscal integration.

Relative Preferences (3-6 months) –

+

USD JPY US Credit EM Rates US Treasuries Europe Credit EM Equities EM Currencies German Bunds EM Credit US Equities Europe Equities Commodities Japan Equities GBP Oil EUR

3

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

The Policy Glass Is Still More than Half Empty Policy shortcomings everywhere have increased the downside risks. Disappointing policy actions by European officials are not surprising anymore, but the Fed’s decision to extend Operation Twist by six months certainly was. By extending Twist six months, the Fed has effectively tied its hands with a policy that has little apparent benefit. It also leaves the markets more vulnerable to negative growth data or stress in Europe, as investors can’t hope for Fed action at the next FOMC meeting. Despite the Fed’s willingness to do more as necessary, and discussion of a globally coordinated monetary policy, a 5-10% sell-off of risk assets probably won’t trigger that response. This lack of a central bank ‘put’ actually increases the risk of a bigger correction, especially with growth slowing globally and still no credible solutions to the eurozone crisis. Post-Greek election, the eurozone policy response remains incomplete. The election result may have reduced the near-term tail risk of a euro exit, but the medium-term outlook is not much clearer. The economy is still depressed, while the eurozone hasn’t made any real progress on institutional reforms. Spanish bank recaps would only provide a temporary reprieve, and not even that if done though the government. Doing so exacerbates rather than breaks the link between sovereign and systemic risk. That explains rising Spanish sovereign yields, even while Spanish equities are also rising (see Exhibit 1). The latter may be anticipating more substantial policy response at the EU Summit on June 28/29. While possible, that’s likely only after the situation has deteriorated further. So it comes back to growth, and that remains weak. The global economy has continued to slow and an inflection point does not appear imminent. Indeed,, over the past month our economists have lowered their 2012 growth forecasts for the US, Brazil, China and India. Among them, only China has the policy flexibility to provide a real boost. We are cautiously optimistic that current policy easing there will provide a boost, but probably not enough to be the catalyst for global growth. Inflation concerns still linger in China, and elsewhere in AxJ, constraining the easing. But DM faces a potentially different problem as inflation, and inflation expectations, continue to fall, a potential harbinger for more growth weakness (see Exhibit 2).

Exhibit 1: Spanish Equities and Yields Both Rising – Something Has to Give 7200

7.3

IBEX (left)

7000

Spain 10y Gov't (%, right)

6.9 6.7

6800

6.5

6600

6.3 6.1

6400

5.9

6200 6000 02-May

7.1

5.7 5.5 12-May

22-May

01-Jun

11-Jun

Source: Bloomberg, Morgan Stanley Research

Exhibit 2: DM Inflation Is Falling, as Are Inflation Expectations 3.5

2.8 2.6

3.0

2.4 2.5

2.2

2.0

2.0 1.8

1.5 1.0 Jan-10

DM CPI (YoY %, left) US 10y Breakeven (right) Jul-10

Jan-11

Jul-11

1.6 1.4

Jan-12

Source: IMF, national sources, Haver Analytics, Bloomberg, Morgan Stanley Research

4

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Despite Expectations of Worse to Come, Markets Are in Risk-Neutral Mode and Pricing Out Tail Risks Markets were relatively sanguine before the Greek election, now tail risks are being priced out. Risk markets faded the Greece election result in a matter of hours. It’s clear, however, that investors started to unwind tail protection with a near-term Greece exit from the euro off the table. While equities were flat, the VIX was down 13% the day after the election, deviating from their normal inverse relationship (see Exhibit 3). The Fed’s surprising action has reversed some of this divergence. But expectations – at least among European and fixed income investors – that things will get worse in Europe before they get better warrants putting on tail hedges rather than taking them off, especially with volatility still lower than it was. Fear was moderating, and the risk regime was becoming neutral. Most sentiment indicators, including the put-call ratio, the AAII bull-bears index and investor surveys, have trended toward risk neutral territory over the past month. Volatility had risen, but only to the middle of the past year’s range. These metrics suggest some investor complacency. That would be more disconcerting if investors weren’t cautiously positioned. Yet it suggests some underestimation of the risks, especially to growth, that are not being priced in all markets. Equities appear more susceptible to any surprises than bonds. After bottoming in early June, the MSCI World index retraced almost half of its losses since April. Correctly anticipating the Greece election outcome could explain part of this. So could expectations for QE3, as even on days of poor data, US equities grinded higher. But with the Fed’s hands now effectively tied, equities are vulnerable to disappointing growth and earnings data. The much larger correction for commodities – due primarily to oil – than equities suggests the latter hasn’t priced in the weakening growth as much (see Exhibit 4). Recent negative earnings guidance, especially from cyclical stocks, is another indication that earnings expectations for 2012 are unlikely to be met, and as soon as the 2Q reporting season. Given these risks and constrained policy response, bonds continue to be more attractive than equities.

Exhibit 3: Volatility Has Fallen Sharply, Suggesting Tail Risks Taken Off 29

VIX (left)

1250

SPX (inverted, right)

1270

27

1290

25

1310

23

1330

21

1350 1370

19

1390

17 15 01-May

1410 11-May

21-May

31-May

10-Jun

1430 20-Jun

Source: Bloomberg, Morgan Stanley Research

Exhibit 4: Commodities Have Fallen Much More than Equities Index Level 1450

Index Level S&P 500

S&P GSCI (r.h. scale)

800

1400 1350 1300

750 700

1250 1200 1150

650 600

1100 1050 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12

550

Source: Bloomberg, Morgan Stanley Research

5

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Staying Cautious, with a Small Shift Toward More Safe Havens We believe the risk-reward skew is worse than the market expects. The combination of slowing global growth, eurozone risks, and insufficient policy responses leaves risk assets vulnerable to larger corrections. Regionally, the US continues to look the strongest on a tactical basis. This is a relative not absolute call on the US; a number of potential potholes lie ahead in 2H12 that could lead to more weakness. EM markets have stabilized, but we would wait for signs that policy stimulus in China is having a noticeable effect, and that funding and deleveraging stress related to Europe are contained. Credit still on top. While valuations are not overly compelling on an absolute basis given the risks, in a slower growth environment credit can do well, especially relative to equities. Europe credit is cheaper than the US and fundamentals are solid, but without a game-changing policy catalyst we will continue to prefer the US.

Asset Class Views (3-6 month view)

– USD JPY US Credit EM Rates US Treasuries Europe Credit EM Equities

Seeking lower beta in equities. Within DM, better growth and lower risks in the US relative to Europe are enough to offset more expensive valuations. AxJ equities are cheap, but we continue to wait for more substantive stimulus from China.

EM Currencies

Neutral on Treasuries, a bit bearish on Bunds. The flight-to-safety bid should also keep yields low for both. While Bunds should retain their safe haven status, positive developments in Europe could reduce that bid and raise yields.

US Equities

Bullish on USD, bearish EUR. Safe haven status supports the USD, and without QE3 downside risk. Short-term capital flows and limited room for JGB yields to fall should help JPY outperformance. EM currencies have stabilized, but remain at risk to funding market stress. Caution on commodities. We see still more downside risk to commodities, as weakness in EM growth is negative for more economically sensitive metals. A stronger USD also works against commodities.

+

German Bunds EM Credit

Europe Equities Commodities Japan Equities GBP Oil EUR

6

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Post-Greece Election: Disaster Averted, Now Back to the Crisis…and Awaiting the Policy Response The fast fade of the Greece election and Spanish bank recap news implies only real reforms will suffice. While the election reduced the tail risk of a nearterm Greek exit, Spanish 10-year bond yields quickly moved above 7%, and Italian curves flattened. Our economists have laid out the reasons why a banking union and a fiscal union are both necessary (see Global Economics: Euro 2012: The Final, June 13, 2012). While the actual implementation of both is at least a couple years away, credible plans and steps in the near term could be sufficient to placate the markets. Unfortunately, we remain sceptical this will happen in the very near term, especially with the ESM unlikely to start on July 1 as scheduled showing the difficulties of institutional reform. The plan for a political plan being drafted by ECB President Draghi and EC President Barroso will be discussed at the June 28/29 EU leaders meeting, but unless market conditions deteriorate significantly, action is unlikely.

Exhibit 5: Spanish Debt to GDP May Be Understated 120

Gov't Debt (% of GDP)

MS forecasts

100 80 60 40 Spain: Liabilities outstanding 20

Spain: Debt according to the EDP Eurozone: Debt according to the EDP

A Spanish bank bailout should be a positive, but the structure will determine just how much. The plan proposed after Spain said it would seek external assistance would not be the necessary circuit breaker between the sovereign and the banking sectors as it reduces bank leverage by increasing public sector debt. Contrary to reports that Spain’s sovereign debt to GDP ratio is actually manageable at just over 60%, a broader measure used by the Bank of Spain puts it at 87% (see Exhibit 5). Adding the full €100bn loan for the recaps would drive that close to 120% over time, an unsustainable level. Without direct funding for the banks, the recaps would be little more than a stop-gap measure in the crisis. The proposed European Redemption Fund (ERF) is a step better, but not the final solution. The ERF combines all government debt exceeding 60% of GDP, creating a very large pool of assets (~€2.5tn), with varying contributions from eurozone members (see Exhibit 6). Core eurozone countries help the periphery by enabling them to lower financing costs. It also addresses the debt overhang by establishing stringent, long-term debt-redemption plans for each country, requiring them to return to 60% debt / GDP over the next 20 years. While the ERF only helps contain the current crisis, it could potentially become a bridge to Eurobonds, which require a greater degree of fiscal integration, a necessary component of any longterm solution. Movement by Chancellor Merkel at the upcoming EU Summit towards supporting the ERF would be a positive step in developing a credible plan for dealing with the crisis.

0 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 Source: Eurostat, Morgan Stanley Research estimates

Exhibit 6: Key Stakeholders in the €2.5tn ERF

Source: Eurostat, Morgan Stanley Research

7

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Eurozone Risk Signals to Watch: Periphery Yields and Curves, Short and Long-Dated Bank Funding Peripheral Front-End Sovereign Yields Have Been on the Rise 8

2y Sovereign Yield (%)

Peripheral ASW Curves Are Near Inversion 250

Germany

7

France

6

Spain

150

5

Italy

100

Italy

0

3

-50

2

-100

1

-150

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Source: Bloomberg, Morgan Stanley Research

EUR/USD XCCY Basis Swap (bp)

0 -50 -100 -150

0

Source: Bloomberg, Morgan Stanley Research

Apr-12

Jun-12

Oct-11

400

(bp)

(bp) 400

Libor-OIS (left)

350

300

-30

250

250

-40

200

200

150

150

100

100

50

50

-80 Jan-11

Feb-12

-20

-90 Apr-10

Dec-11

350

-70

3y (right)

Jul-09

Oct-11

-10

-60

3m (left)

Oct-08

Aug-11

Funding Stress Subdued but Term Financing Costs Troubling

-50

-200

-200 Jun-11

Source: Bloomberg, Morgan Stanley Research

Longer-Maturity EUR Basis Swaps Show More Stress

-250 Jan-08

• With a number of key policy events coming up in Europe, markets could come under stress. A number of market indicators bear close watching.

Spain

50

4

0 Jun-11

ASW 2s10s

200

0 Jan-08

Euribor-Eonia (left)

300

iTraxx Snr Fin (right)

0 Oct-08

Jul-09

Apr-10

Jan-11

Oct-11

• 10y sovereign peripheral yields are rising, but the more concerning is the rise in 2y yields. Such curve flattening and near inversion is a warning of default and impairment. The rise in 2y yields also indicates that the LTRO effect has worn off. despite LTRO support. • In funding markets, shorter-dated measures look relatively subdued but longer-dated ones are also important. The 3y EUR basis swap shows far more stress than the 3m, and term financing costs are troubling even though indicators like Libor-OIS are calmer.

Source: Bloomberg, Morgan Stanley Research

8

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Growth Is Still Trending in the Wrong Direction, and China May Not Be Enough to Reverse That Growth in all corners of world is slowing, with no sign of an imminent turnaround. Few countries have proven immune to the slowdown and the negative implications of the sovereign crisis. In the past month, our economists have taken down their 2012 GDP forecasts for the US and the UK and three of the four BRICs: Brazil, India, and China (see Exhibit 7). EM was, and still is, the main engine of global growth, and most countries have the policy flexibility that DM countries do not to stimulate their economies. But that good news is offset by the structural challenges many still face over the next few years, with India’s current difficulties a case in point (see The Global Macro Analyst: Can We Depend on EMs to Keep Driving Growth?, May 16, 2012). That puts most of the onus for spurring growth on China’s policy easing. The policy rate cut indicates increasing concern by Chinese officials, and more stimulus is likely. But that’s against a backdrop of still slowing growth in China (see Exhibit 8). The net result may be more about reducing growth tail risks rather than improving global growth prospects.

Exhibit 7: Growth outlook is lower in both DM and EM 2011E

2012E

2013E

June

April

Chg

June

April 4.0

GLOBAL

3.9

3.6

3.7

▼

4.0

G10

1.3

1.4

1.3

▲

1.6

1.6

1.7

2.1

2.2

▼

1.6

2.1

US Eurozone Japan UK EM

1.5

(0.3)

(0.3)

0.9

0.9

(0.7)

2.3

1.8

▲

1.0

0.9

0.7

0.5

0.7

▼

1.8

1.8

6.4

5.7

6.1

▼

6.2

6.3

China

9.2

8.5

9.0

▼

9.0

8.6

India

7.1

5.7

6.9

▼

6.5

7.5

Russia

4.3

5.0

5.0

4.0

4.0

Brazil

2.7

2.7

3.5

▼

3.4

4.2

Source: Morgan Stanley Research YoY % forecasts

Exhibit 8: China’s latest consumption and investment data disappointed 24

(YoY %)

(YoY %)

34

22

32

20

30 28

18

26 24

16

22

14 12 Jan-06

36

20

Retail Sales (left) Fixed Asset Investment (right) Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

18 Jan-12

Source: NBS, Haver Analytics, Morgan Stanley Research

9

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

EM Markets Have Stabilized, but They’re Not Out of the Woods as Challenges Remain EM Currencies Improved This Month and Funding Stress Fell

37

12

MS EM FSI (left)

101

10

USD/EM (right)

99

8

97

6

95

4

93

2

91

0

89

-2

87

-4 Oct-07

32 27 22 17 12 Jan-11

Apr-11

Jul-11

Oct-11

Jan-12

Apr-12

Source: Bloomberg, Morgan Stanley Research

20

80

15

60

10

40

5

20

0

0 Industrial Production (YoY %, left)

-5

-20

Exports (YoY %, right) Nov-09

May-10

Nov-10

May-11

• EM asset markets stabilized after selling off in May. Funding stress eased modestly as the near term tail risks for Greece eased. Investors are also only moderately positioned. India Singapore Oct-08

Oct-09

Oct-10

Korea Taiwan Oct-11

Source: IMF, national sources, Haver Analytics, Bloomberg, Morgan Stanley Research

India’s Industrial Production and Exports Both Declined

-10 May-09

CPI (%Y)

103

47 42

EM Inflation Is Still Relatively High

Nov-11

Source: CSO, DGCI&S, Bloomberg, Morgan Stanley Research

-40 May-12

Brazil’s Weak Industrial Production Is Pressuring Growth 145

(2002=100)

140

Industrial Production

135

Economic Activity Indicator

130 125 120 115 110 105 100 Jan-06 Oct-06 Jul-07 Apr-08 Jan-09 Oct-09 Jul-10 Apr-11 Jan-12

• However, the economic environment remains challenging. Inflation has stopped falling in some major AxJ economies, limiting policy flexibility. • India’s growth is weak on multiple metrics, while inflation is still high, keeping the RBI on hold at its recent meeting. A poor balance of payments makes India vulnerable to external shocks. • Brazil’s first quarter GDP confirmed output slumped, and weak industrial production indicates a further slowdown.

Source: IBGE, BCB, Morgan Stanley Latam Economics

10

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

The Risk Regime Is Not at Extremes, While Correlations Suggest it Is Changing Equity Vol Has Moved Higher, but Not to Crisis Extremes 55

All Asset Class Vols Are Higher, but Still Middle of 1-Year Range 88 93

Implied Volatility (%)

50

S&P 500

45

81

78 80

35

131

106

140

93

FX

30

99

25

128

199

143

Credit

20

82 83

15

165

113

Commodities

Jul-10

Jan-11

Jul-11

May 1, 2012

Jan-12

Source: Bloomberg, Morgan Stanley Research

Current

Source: Bloomberg, Market1, Morgan Stanley Research Note: Indexed implied volatility, 1-year range.

Gold-Equity Correlation Has Turned Negative… 1.0

87

Rates

Eurostoxx

40

10 Jan-10

177

112

Equity

30-day Return Correlation: Gold and S&P 500

0.8

…While EUR / SPX Correlation Has Also Fallen Close to 0 1.0

30-day Return Correlation: EUR/USD and S&P 500

0.8

0.6

0.6

0.4 0.2

0.4

0.0

0.2

-0.2 -0.4

• Rising market caution is evident in risk measures. Volatilities for all asset classes moved substantially higher from early May levels, but recently fell back on improving sentiment as Greek tail risk exits fell. Even so, volatility is still in the middle of 1-year ranges across asset classes. • Cross-asset correlations are also suggesting a more risk-off to risk neutral environment. The fall in the gold-equity correlation was to levels similar to the sell-off last summer. The breakdown in the EUR-equity correlation implies that the EUR is no longer a risk-on currency, and has more room to fall.

0.0

-0.6 -0.8 Jan-10

Jul-10

Jan-11

Source: Bloomberg, Morgan Stanley Research

Jul-11

Jan-12

-0.2 Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Source: Bloomberg, Morgan Stanley Research

11

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Equities Base Case: Maintain Defensive Positioning • We would maintain a defensive sector allocation, given slowing global growth and the eurozone crisis that is far from resolved. The Fed’s decision to extend Operation Twist through year-end leaves equities particularly vulnerable to disappointing economic data and earnings or additional sovereign stress in Europe. In a yield and carry environment, we continue to favor dividend paying stocks and high quality large caps, as investors are not being paid to hold cyclicality.

Views US

–

+

–

+

–

+

Utilities Healthcare

• On a regional basis, our tactical preference remains the US, though the risks are to the downside. After reducing our allocation to EM equities last month, we would hold steady for now. Easing by China and relatively cheap valuations compared to history point to upside on a strategic view. But we expect EM equities to continue to trade as high beta for now, vulnerable to US growth weakness and funding stress and bank deleveraging emanating from Europe. Our Japan equity strategy team raised their target to 880 on the TOPIX, partly on the basis of 52%Y EPS growth, but the poor global outlook tempers our view to upgrade Japan at this time.

Materials Cons Staples Tech Energy Financials Telecom Cons Disc

• A headwind for equities is the negative guidance for 2Q earnings and the possibility of disappointing results. Negative earnings revisions have started to outnumber upgrades in both the US and Europe. This has been led primarily by revisions to cyclical sectors, due to poor Europe growth for European stocks and global growth for US cyclicals. Looking further out, 2013 US earnings expectations are about 20% above what our US equity strategist Adam Parker expects. The extension of Operation Twist for six months adds to the year-end policy uncertainty with the fiscal cliff looming, which is likely to be a constraint on corporate activity and earnings. MS Top-Down Estimates below the Bottom-Up Consensus Morgan Stanely versus Consensus S&P 500 Earnings Estimates as of May 2012

Industrials Europe Healthcare Materials Telecom Cons Staples

Consensus Earnings Estimates Coming Down after Rising Annual S&P 500 Consensus EPS ($) 125

Consensus MS Estimates

Financials Cons Disc

$118.29

115

China

2012E

$100

$99

105 100

Industrials EM

110

$106

Utilities Energy

2013E

120

$118

Tech

$105.84 2011

$97.57

95

Russia Korea Indonesia Brazil Taiwan

2012E

Source: FactSet, Morgan Stanley Research

2013E

90 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12

Source: Thomson Financial, S&P, Morgan Stanley Research

India Turkey Mexico

12

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Valuation Attractive in Europe and Japan, but Still Prefer the US DM Dividend Yields Are Compelling Relative to History Dividend Yield - 10Y Bond Yield

European Cyclicals vs. Defensives Earnings

Dec-07 Dec-10 Today

2.5% 2.0% 1.5%

25

• Dividend yields, relative to bond yields, are at very attractive level for most DM countries, particularly in Europe. Eurozone risk outweighs these cheaper valuations as compared to the US.

European Cyclicals vs Defensives Relative FY1 Earnings Revisions Ratio (%)

20

3MA

15 10

1.0% 0.5%

5

0.0%

0

-0.5%

-5

-1.0%

-10

-1.5%

-15

-2.0% -2.5% US

Germany

UK

Japan

Italy

Spain

Source: MSCI, Datastream, Morgan Stanley Research

-20 2006

2009

2010

2011

2012

Japanese Manufacturing Earnings Rebound 50%

3.0

40%

2.5

60

30%

2.0

40

20%

1.5

20

10%

1.0

0

Japanese Economic Surprises 3m trailing Topix returns (r.h. scale)

80

2008

Source: Datastream, Morgan Stanley Research

Japanese Equities Loosely Track Economic Surprises 100

2007

%

Earnings Environment Indicator Corporate Sector Overall Manufacturing Only

0%

0.5

-20

-10%

0.0

-40

-20%

-0.5

-60

-30%

-1.0

-80

-40%

-1.5

-50%

-2.0 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

-100 Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Source: Bloomberg, Morgan Stanley Research

Jan-11

Jan-12

Source: MSCI, Morgan Stanley Research

• In Europe, Spanish equities are relatively cheap compared to Italy, one of the few countries whose bond yield exceeds its dividend yield. A positive Spanish bank recap could serve as a catalyst to prefer Spanish over Italian equities. • Earnings revisions have been trending lower in Europe and the US, led by cyclicals. But an earnings indicator for Japan points to more upside. • However, if the situation deteriorates significantly in 2H, we might see a strong policy response, which could really change the risk outlook. 13

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Credit Base Case: Prefer Credit for Yield and Carry in a Low Growth Environment • Credit continues to be attractive after trading mostly sideways for the past month. Spreads in the US and especially Europe now look wide of fair value, but eurozone risk could keep credit from tightening much in the near term. Slowing growth is a concern, but the sweet spot for credit is often around 2% in the US as it encourages corporate conservatism.

Views

–

+

US HY

• Rising sovereign and funding stress in Europe has resulted in wider IG spreads relative to high yield; prior to this decompression of IG the ratio of HY to IG spreads was at high levels, especially in the US. In Europe, Financials and corporates exposed to peripheral Europe have underperformed. In Asia, further policy easing is supportive of HY, and improving credit conditions have boosted China HY resilience.

CMBS Asia HY CLO US Financials UK RMBS

• The move wider in IG has been driven by Financials, more so in the US, while in Europe its been peripheral corporates. Given the risks in Europe, US and UK are our preferred way to take ‘beta’ exposure. Until there is a credible plan to recap Spanish banks and a clearer roadmap for Europe, we wouldn’t add risk to European financials at this time.

Asia Financials US IG Asia IG Europe IG

• Our US IG strategy team now has a modest OW for the sector and expect the cash index to be at 195bps of OAS by yearend. For HY, the US offers a better fundamental and structural story with less tail risk exposure than Europe, the latter does offer attractive valuations, which is most pronounced in single Bs.

IG Has Underperformed HY, Led by Financials

6.5

RMBS

Basis points (bps)

iTraxx Senior Financials

335

CDX HY / CDX IG XOver / Main

Europe HY

Senior Financials Have Widened Significantly Basis points (bps)

7.0

EU Financials

400

iBoxx Financials (r.h. scale)

315

380 360

6.0

295

5.5

275

5.0

255

4.5

235

4.0

215

260

3.5

195

240

3.0 Jan-10

Jul-10

Jan-11

Jul-11

Source: Bloomberg, Morgan Stanley Research

Jan-12

175 Jan-12

340 320 300 280

220 Feb-12

Mar-12

Apr-12

May-12

Jun-12

Source: Bloomberg, Morgan Stanley Research 14

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Valuations Are Attractive, but We Prefer US over European Credit US IG Spreads – Modestly Tighter as a Base Case

3-7y Maturities Offer Very Efficient Spread & Excess Return 1-3

IG Spreads - Historical and Projected

(bp) 300

248 211

200

3-7

195 143

90%

48%

45%

21%

21%

26%

28%

6%

6%

Volatility

Total Return

70% 60%

22%

50% 30%

34%

20% 10%

Jul-10

Jan-11

Jul-11

Historical Spreads

Jan-12

OAS

Spread Target

Source: YieldBook, Morgan Stanley Research

Source: YieldBook, Morgan Stanley Research

Biggest European Premium Is in Single Bs 16% 14% 12%

Sub-6% Issuance Is Rising 15.0

Europe 11.2

56.2

40.0

37.5

7.8

7.6

20

6.7

6%

20.4

0.8 0 2006

4% HY

BB

B

Source: YieldBook, Markit iBoxx, Morgan Stanley Research

CCC

24.5

20%

14.7

14.3

10

5.9

40% 30%

30

8.3

50%

50 40

10% 8%

USD HY New Issuance by Yield

($B) 60

12.4

US

12%

0%

Jul-12

Current Spread

• The base case for our US IG credit strategy team is for a 12bps tightening from current levels by year-end. They favor Non-Financial BBBs in the 3-7 year range, as they offer the highest spread relative to volatility.

10+

32%

80%

40%

100

0 Jan-10

7-10

100%

0.2 2007

Under 6%

0.0 0.0

0.6 0.0

2008

2009

6 - 7%

10%

4.4

0% 2010

2011

2012

Under 7% as % of Total Issuance (RS)

Source: Morgan Stanley Research

• US high yield offers a better fundamental and structural story than Europe, but the latter does provide attractive valuations: for example, the single B bucket offers a 3.0% yield premium, which more than compensates for higher default risk. • In a low yield environment, high quality issuers have an incentive to relever given low funding cost options. The result is that in 2012 YTD, the US HY market has issued more sub-6% debt than from 20062011 combined. 15

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Rates Base Case: Neutral DM Rates, Look for Improvement in EM Risk/Reward • We remain neutral on Treasuries and prefer the belly of the curve (3- to 7-year maturity sectors). Our interest rate strategy team forecasts the 10y at 1.90% by year-end, based on the Fed’s continued balance sheet action and weak growth.

Views

– • As the Fed extends its Maturity Extension Program (MEP) for another six months – purchasing Treasuries with remaining maturities of 6 to 30 years and selling Treasuries with remaining maturities of approximately 3 years or less – and pressures longer-term rates downward, the belly of the 7s15s30s curve should outperform. Real rates have room to rise in the front end as realized inflation moderates.

+

EM local curve EU curve US curve EU spreads US spreads

• We stay neutral on Bund duration due to the influence of peripheral spreads on rate expectations. Bunds are currently rich in light of policy expectations; our European economists expect a 25bp rate cut by 3Q12. The ECB is also likely to be constrained from tightening for a long time, supporting the case for roll and carry strategies.

US duration US volatility EU duration EM spreads

• We favor long 10s on the 2s10s30s fly: 2s sell off in a bear case while roll and carry support the 10s in a bull case. Bunds sold off recently, but we believe this was due to technical factors rather than peripheral risk spreading to the core. Indeed, CDS are well-behaved and the euro has strengthened, underscoring our view that the Bund “safe-haven” story still rings true.

EU volatility EM local dur.

• EM credit may find some relief after Greek elections and Fed announcement, but a number of risks loom: decelerating growth, tight lending conditions from European bank deleveraging, and the potential for greater funding stress from Europe. However, positioning is relatively light and valuations weak. EM local rates may find support from policy – the market Is largely pricing holds or cuts across EM – but relatively high inflation may constrict options. Neutral Bund Duration on Rate Expectations

The Market Is Pricing Holds or Cuts across EM

4.0

40

3.5

Bund 2y

3.0

Bund 10y

0

2.5

-20

2.0

-40

1.5

-60

1.0

3m

6m

9m

-80

0.5

Source: Bloomberg, Morgan Stanley Research

CLP

BRL

HUF

KRW

ILS

CZK

Apr-12

ZAR

Jan-12

MYR

Oct-11

PLN

Jul-11

TWD

Apr-11

MXN

-100 THB

0.0 Jan-11

(bp)

20

Source: Morgan Stanley Research 16

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Weak Growth Suppressing US Rates; the Belly of the Bund Curve Remains Attractive GDP Growth, Not Unemployment, Is Key for Bond Yields

The Fed Moved as Financial Conditions Remain Tight 2.5

6

Tighter Conditions

2.0

(%)

5

MS FCI

1.5

(%)

4

1.0 0.5

JGB 10y

3

Japan Unemployment Rate

0.0

2

-0.5

1

-1.0 -1.5 Jun-11

Looser Conditions Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Source: Bloomberg, Morgan Stanley Research

170

2.0

150

1.5

130

1.0

110

0.5

90

0.0

30 Jan-09

Jan-02

Jan-05

Jan-08

Jan-11

Swap Yield (%)

EUR JPY JPY - EUR

-0.5

Bund 2s10s30s

50

Jan-99

10s Should Perform if European Rates Follow Japan’s Path 2.5

(bp)

70

Jan-96

Source: Bloomberg, Morgan Stanley Research

Bund 2s10s30s Held Up Well Even in the Recent 10y Sell-Off 190

0 Jan-93

-1.0 -1.5

Jul-09

Jan-10

Jul-10

Jan-11

Source: Bloomberg, Morgan Stanley Research

Jul-11

Jan-12

0

5

10

15

20

25

Tenor (y) 30

• The Fed’s move to extend its MEP is good news for financial conditions, which have been tightening. • We remain neutral Treasury duration on weak growth, even with falling unemployment. Japan experienced falling unemployment, from 5.5% to 3.6% during 2002-07, yet JGB 10y yields were mostly unchanged as real GDP growth slumped. • In Europe, we continue to like 10s on the 2s10s30s fly. In a downturn, the volatile front end typically causes 2s10s to flatten more than 10s30s. In a bullish ‘Japan’ scenario where policy rates stay low for an extended period, gradual curve flattening should lead to 10y outperformance.

Source: Bloomberg, Morgan Stanley Research 17

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

FX Base Case: Continued Preference for USD and JPY, Continued Downside Risk for EUR and EM • We still like the USD and expect it to rise on safe-haven flows and as central bank currency reserve demand drains USDs from the private sector. Short-term capital flows and limited room for JGB yields to fall are supportive of JPY outperformance, though a surprise BoJ move to increase the size or maturity of its asset purchases could weaken the JPY.

Views

–

+

JPY

• The EUR has benefitted from the suppression of immediate risks in Greece and Spain, but this strength should be short-lived due to the eurozone’s weak macro, the likelihood of the ECB cutting rates, and the possibility that the ECB will consider EURweakening policies to support growth. Though the EUR is not yet a funding currency, there is increasing incentive to use it as one; this would be another source of downward pressure for the EUR.

USD NOK CNY MXN MYR

• As eurozone crisis continues, the SNB will need to buy more foreign currency to defend its 1.20 EUR/CHF floor, but this unsustainable balance sheet expansion may break and cause the EUR/CHF to fall to 1.10 in 3Q.

PLN RUB KRW

• High-beta G10 currencies (e.g., AUD, NZD, CAD) have recently rebounded, but we see limited scope for this to continue due to declining interest rates, rising volatility, slowing growth and lingering risks. In contrast, we’re constructive on NOK due to its hawkish central bank and strong economy.

CHF SGD BRL TRY

• AxJ currencies could see a tactical rally as the bad news on the global front looks like its already in the price. However, AxJ currencies are facing three fundamental headwinds: 1) AxJ currencies are high-beta to the weak global cycle; 2) growth is decelerating below trend and external surpluses are declining; and 3) narrowing interest rate differentials.

ZAR CAD GBP AUD NZD

High-Beta Currencies Vulnerable if Sentiment Falls

Short Volatility Strategies Are No Longer Performing

4.0

1.10

3.0

1.08

2.0

1.06

1.0

1.04

0.0

1.02

-1.0

1.00

-2.0

0.98 Standardized GRDI (left)

-3.0 -4.0 Sep-11

0.96

AUD/USD (right) Nov-11

Jan-12

Mar-12

Source: Bloomberg, Morgan Stanley Research

0.94 May-12

110

MS Short Volatility Benchmark USD (left)

1.10

SEK

1.05

CAD/USD (right)

105

EUR

1.00 100

0.95 0.90

95

0.85

90

0.80 85 80 Jun-07

0.75 0.70 Mar-08

Dec-08

Sep-09

Jun-10

Mar-11

Dec-11

Source: Bloomberg, Morgan Stanley Research 18

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Risk-Reward Views

Note: E = Morgan Stanley Research estimates, unless otherwise indicated

19

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Global Economics Risk-Reward View What’s in the price?

Investor Debates  Euro Area: Will Spain lose market access? Will Greece exit?  US: Whither the economy? Will recent Fed action help?  China: how much stimulus and will it help?

Base Case / Thesis

2012 Global GDP: 3.5%

 Spanish (and Italian) yields near highs. Euro strengthened following Greek election.  Despite a good earnings season, both US Treasuries and stocks have been driven by euro-related concerns lately.  Markets have rallied on recent RRR cuts, suggesting policy-makers will ensure soft landing.

 Bull Case

2012 Global GDP: 4.2%

Bumpy, below-par and brittle DM recovery ongoing, despite headwinds from ‘triple deleveraging’ in DM (US households, eurozone sovereigns and banks) and, on and off, oil prices. The expansion will continue to be propped up by the ‘Great Monetary Easing, Part 2’ as a large number of central banks globally deliver more easing over the next few quarters. This recovery is unusual in that it features a great deal of divergence: between DM and EM (which generates 80% of global growth), within G3 (where the US outperforms Europe and Japan) and within the eurozone, where the periphery slides deeper into recession while the core is exiting a mild recession.

Our bull case assumes that oil eases back to US$100, global trade is 2pp faster than in the base case, risk markets continue to do well and there is a little less US fiscal tightening in 2013.

Key Indicators

Global GDP: Base, Bear and Bull

2011E

Bear Global GDP

G10 GDP

EM GDP

2013E

2.7

3.0

3.5

3.9

Bull

4.2

4.6

Bear

0.5

0.3

Base

Base

3.9

4.0%

2.5

Bear

4.9

5.5

5.7

6.2

1.0%

6.5

6.7

0.0%

Base Bull

4.4

3.6

3.0

3.5

3.2

3.4

3.4

2012 Global GDP: 2.7%

Global GDP

1.4

Bear

November US presidential elections

5.0%

1.8 6.4

2H12 China leadership transition begins

6.0%

1.3

Base

1.3

July 1 ESM starts to operate alongside EFSF

Our bear case is built on (i) a supply shock taking oil to US$150, (ii) halving of world trade growth, and (iii) significantly wider euro area bond yield spreads as debt concerns flare up again. In this scenario, global growth is close to the recession threshold of 2.5%. Note this is not a super-bear case, which could result from Greek euro exit with systemic knock-on effects.

Bull

Bull Global Inflation (CPI)

2012E

 Bear Case

Signposts

3.0% 2.0%

Bear

Base

Bull

-1.0% 1995

1997

1999

2001

2003

2005

2007

Source: Morgan Stanley Research estimates

Joachim Fels, Manoj Pradhan, Spyros Andreopoulos (44 207) 425-6138, [email protected]

2009

2011

2013

20

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

US Economics Risk-Reward View Investor Debates

What’s in the price?

 What are the downside risks from potential fiscal tightening and contagion from Europe?  What additional steps could the Fed take and when? Will we have QE3?  Will Congress be able to agree on any extension or expansion of fiscal stimulus for next year and a credible longer-term plan to stabilize the debt/GDP ratio?

 The weak employment report and renewed strains in Europe have futures markets back to pricing the Fed on hold through mid-2014.  On the other hand, while we see a one-in-three chance of Operation Twist being extended past June, our desk now sees very little prospect of additional Fed easing as being priced into rates markets.

Base Case / Thesis

2012 GDP: 2.1%

Rising uncertainty tied to the fiscal cliff confronting the US and an intensification of the European debt crisis have triggered a significant tightening in US financial conditions over the past few months. Moreover, these developments appear to have contributed to deterioration in the incoming economic data. As a result, we cut our second half GDP growth forecast to show no acceleration relative to the estimated +2% or so pace seen in the first half of the year. And, with less forward momentum than previously thought heading into late 2012, the vulnerability of the US economy to some fiscal drag in early 2013 should be more pronounced, leading us to cut our GDP forecast for next year to 1 3/4% from 2%. Risks remain tilted to the downside. In addition to European risks, a potential 5% of GDP fiscal tightening in calendar year 2013 would almost certainly cause a recession if implemented. While it is likely that legislation will eventually be enacted to avoid the full impact of the fiscal cliff, it’s quite possible that we will see a repeat of the scenario that played out last summer when Congress dragged their heels in hiking the debt ceiling and US sovereign debt was downgraded.

Key Indicators GDP

CPI

Unemployment

Policy Rates (EOP)

 Bull Case

June 28 1Q12 GDP Revision July 6 June Employment Report July 17

2012 GDP: 2.5%

June CPI

Our global bull case assumes a sustained moderation in oil prices to $100 a barrel around mid-year and a significant pickup in global trade. Additionally, our U.S. bull case assumes partisan compromise after the elections allows significant fiscal tightening to be put off until after 2013.

 Bear Case

July 27 2Q12 GDP July 31 FOMC meeting

2012 GDP: 1.7%

Our global bear case assumes a supply shock that drives oil prices to $150 a barrel at mid-year, sustained through 2013. Under this scenario, we see U.S. GDP growth stagnating in the second half of 2012 through early 2013. There is also an important domestically focused bear case surrounding U.S. fiscal policy. Under current law, there would be a tightening of fiscal policy approaching 5% of GDP in 2013, much bigger than our 1.5% base case. Total gridlock after the elections that prevented current law from being changed would likely result in recession.

Aggregate Weekly Payrolls Show some Weakness 2010

Bull Base Bear

Signposts

3.0

1.6

9.6

0.125

2011E 1.7

3.1

8.9

0.125

2012E

2013E

2.5 2.1 1.7 1.5

2.5 1.6 0.7 1.0

1.9

1.5

2.9 7.8 8.2 8.5 0.15 0.15 0.15

2.5 7.0 8.1 8.5 0.15 0.15 0.15

1.0

1.0

Aggregate Weekly Payrolls: Total Private Industries % Change MoM

0.8

0.8

0.6

0.6

0.4

0.4

0.2

0.2

0.0

0.0

-0.2

-0.2

-0.4

-0.4

-0.6

-0.6 Jul-11

Aug-11

Sep-11

Oct-11

Nov-11

Dec-11

Jan-12

Feb-12

Mar-12

Apr-12

May-12

Note: Aggregate Weekly Payrolls combines employment, hours and earnings. Source: Morgan Stanley Research

David Greenlaw, (212) 761-7157, [email protected]

21

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Europe Economics Risk-Reward View Investor Debates

What’s in the price?

 Will Spain finally address the issues with the banks and with the autonomous regions? Will Greece be forced to leave the euro area? Will the firewalls be able to contain the consequences? Is EMU becoming more focused on growth and less on austerity after the French election? Is Germany willing to accept higher inflation and higher wages?

    

Base Case / Thesis

 Bull Case

2012 GDP: -0.3%

Taking on board downside risks from additional austerity measures and rising funding costs, consensus expectations have now started to undershoot our GDP forecasts for the euro area. The assumption underlining our base case growth projections is that the sovereign debt turmoil won’t be allowed to escalate further but that it won’t dissipate quickly either. In the interest of providing a ‘clean’ reading of the cyclical dynamics, we have to assume continued ‘muddling through’ even though this piecemeal policy is being challenged by financial markets. Our base case is hence one of a relatively benign recession that gives way to a muted recovery in 2H.

Key Indicators

Base

2011

2012E 0.5

1.3

2.2

1.5

-0.3

0.9

1.4

-1.5

0.0

0.6

2.1

1.8

2.4

Bear CPI

Unemployment Rate (%)

Policy Rates (EOP)

2012 GDP: 0.5%

We should not lose sight of the positive factors. These could include additional ECB easing (a further 25bp of cuts), a much weaker EUR and relatively robust global growth. In addition, the successful LTRO is likely to have avoided a credit crunch and strong corporate balance sheets should provide a cushion against banks tightening credit conditions in the future.

 Bear Case

2012 GDP: -1.5%

With the current piecemeal approach chosen by policy-makers not convincing markets, the sovereign debt problem could escalate further still. A credit crunch and confidence crisis will cause a deep recession and even a risk of deflation in 2013. Eventually, the ECB would likely respond with aggressive QE via outright asset purchases rather than refi operations.

Bull, Base and Bear Cases – ECB Refi Rate

Bull GDP

Signposts

GDP contraction of -0.4% in 2012, recovery to 0.7% in 2013. Headline inflation to ease to 2.3% in 2012, 1.6% in 2013. ECB watchers expect no refi rate cuts in 2012. Ten-year Bund yields to rise to 2.1% by June 2013. EUR/USD at 1.25 in Sept 2012 and at 1.25 in June 2013

2.7

10.2

1.00

2013E 2014–2018E

June 21/22 Eurogroup & Ecofin meeting June 22 Merkel, Monti, Rajoy and Hollande meet in Rome June 29 Bundestag to vote on Fiscal compact and ESM June 28/29 European Council meeting July 1 ESM starts to operate alongside EFSF July 5 ECB Council Meeting & Press Conference BoE MPC meeting August 2 ECB Council Meeting & Press Conference

4.5 4

August 2 & 8 BoE MPC meeting and inflation report

3.5

Base Case Refi Rate

3

September 13/14 G20 Finance ministers and Central Bank Governors meeting

2.5

2.3

1.6

1.9

2.5

0.6

1.4

10.2

10.8

1.5

10.9

12.3

1

11.9

12.3

0.5

1.25

1.50

0.75

1.00

0.25

0.25

2

1.25%

0.75%

0.25%

0 Jan-07

Jan-08

Jan-09

Jan-10

Source: Morgan Stanley Research estimates

Elga Bartsch, (+44) 207 425 5434, [email protected]

Jan-11

Jan-12

22

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Japan Economics Risk-Reward View Investor Debates

What’s in the price?

Signposts

 Will the high-tax, high-spending approach of the LDP and the DPJ remain intact?  How much additional monetary easing is likely with renewed political pressure on the BoJ and when?  Will a delay in fiscal reforms raise the risk of European contagion to Japan’s sovereign markets?

 The initial positive reaction to the BoJ’s easing on February 14 faded in the equity and forex markets, as investors are more skeptical about the BoJ’s determination to achieve the inflation target, due to the lack of aggressive action.  JGB yields are more heavily correlated with Treasuries and Bunds, due to European disturbances. Recently, the Bund correlation has risen.

Political Disarray PM Noda said he will stake his political career on passage of the tax hike bill (to raise the VAT rate in two stages from April 2014) within the current Diet session. Consensus sees passage, but political turmoil (e.g., vote of no confidence) remains possible.

Base Case

 Bull Case

2012 GDP: 2.3%

We raised our real GDP forecasts to +2.3% for 2012 (prev. +1.8%) and to +1.0% for 2013 (prev. +0.9%) on May 21. The upward revision in our outlook stems from unexpectedly brisk GDP growth in 1Q12 and an retroactive upward revision in 4Q11 growth. On the fiscal front, outlook of tax and social security reforms including higher consumption tax is highly uncertain. Our revised outlook does not factor fully for a consumption tax hike from April 2014. We do not expect the BoJ’s 1% inflation target to be reached by end-F3/14. The BoJ will continue to face strong political pressure for additional easing.

Key Indicators GDP CPI (JPN Core) Unemployment Rate Call Rate (EOP)

Bull Base Bear Bull Base Bear Bull Base Bear Bull Base Bear

2011 -0.7 -0.7 -0.7 -0.3 -0.3 -0.3 4.5 4.5 4.5 0.05 0.05 0.05

2012E 2.8 2.3 0.6 0.5 0.2 -0.3 4.3 4.6 5.0 0.05 0.05 0.05

2013E 2.0 1.0 -0.9 0.2 -0.3 -0.9 4.0 4.6 5.6 0.05 0.05 0.05

2012 GDP: 2.8%

Upside risks include (1) a lower oil price as geopolitical risk subsides, (2) a better sovereign debt situation in Europe, and (3) gains in asset markets as Great Monetary Easing spreads globally.

 Bear Case

2012 GDP: +0.6%

Despite our upward revision, we still see the risk profile as skewed to the downside. The risks include (1) renewed concerns about European sovereign debt, (2) slowdown in Asia, and (3) the prospect of sharp fiscal tightening in the US in 2013 (the ‘fiscal cliff’). A snap general election in Japan would also exacerbate rather than soothe political disarray.

2014-17E 1.3 1.0 0.0 1.0 0.5 -0.5 4.0 4.5 5.7 1.00 0.50 0.05

Japan’s Real GDP Growth Scenarios 6 4

2.8

2

2.0

2.3

0

1.0

0.6 -0.9

Electoral Reform Debate will begin in earnest on electoral reform in the Upper House and the Lower House, in light of 2011/3/23 ruling by Supreme Court in favor of oneperson-one-vote. Such a system is likely to be adopted; however, the change of incentives faced by politicians would depend on the size of the reform. A large reform means smaller government and economic efficiency. A small reform means status quo continues.

-0.7

-2

Bull Base Bear

-4 -6 2007

BoJ: Intense Political Pressure Though the BoJ expanded its asset purchase program on April 27, its bullish view on prices sent a contradictory message. The prevailing political climate makes an end to easing unlikely. That said, Europe election results and stable yen may give the BoJ time to postpone action, even past July.

-5.5 2008

2009

2010

2011

Source: Morgan Stanley Research estimates

Robert Feldman, +81 3 5425-5385, [email protected]

2012e

2013e

23

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

China Economics Risk-Reward View Investor Debates How will the global slowdown impact Chinese growth? Does current economic situation warrant more policy easing?

What’s in the price?

Signposts

 Market has priced in a soft-landing path for economic growth. The weak macro indicators in April and May had led to rising expectations of more monetary and fiscal policy easing.

The release of the 2011 Central Government Final Accounts Report in June / July 2012 by the MoF 2Q12 macro datapack to be released in early July

Base Case / Thesis

2012 GDP: 8.5%

2012 – More effective policy easing to support growth acceleration in 2H12: We lowered our real GDP growth forecast to 8.5% YoY from 9.0% YoY, reflecting the worse than expected slowdown YTD and the later-than-anticipated start of policy easing. However, the timely RRR and interest rate cuts in response to the weaker-than-expected macro data suggest that policymakers see the urgent need to intensify policy easing measures. The downward trend in inflation also serves to ease the central bank’s concerns about rekindling inflation pressures. In the near term, we expect more aggressive policy to support demand growth in the form of 1) an interest rate cut in late 3Q/early 4Q12; 2) multiple RRR cuts; 3) suspension in CNY appreciation against the USD, and 4) more government-led infrastructure investment and SOE-led manufacturing investment projects.

Key Indicators

Bear

3.1

2.2

3.4

2.9

2.0

NA

NA

2.0

1.7

NA

NA

10

5

0 3Q13E

Bull Trade Balance Base (% of GDP)

3.8

1Q13E

Bear

3.3 3.2

1Q12

5.4

3Q12E

3.3

3Q11

Base

1Q11

Bull CPI

15

3Q10

7.6

MS Forecast

20

1Q10

7.7

GDP (%, QoQ, SAAR)

3Q09

9.0

1Q09

8.5

GDP (%, YoY)

3Q08

9.3

9.2

% 25

1Q08

8.7 10.4

Bear

2013E

3Q07

2012E

1Q07

2011

3Q06

2010

1Q06

Base

 Bear Case 2012 GDP: 7.7% A combination of external shocks (e.g., an oil price jump from July onwards in 2012 and overhang from European debt crisis), as well as the potential over-tightening in the property market with policy responses coming in too little, too late, will together lead to further demand weakness amid deflationary pressure.

China: A Stronger Rebound in 2H2012

Bull GDP

Bull Case 2012 GDP: 9.0% If the developed markets’ growth led by the US turns out to be stronger than expected, the recovery will boost global exports and help China grow more rapidly. In addition, the more proactive fiscal policy (budgeted at 1.5% of GDP vs. actual fiscal deficit of 1.1% of GDP in 2011), if implemented, will prove to be stimulative to aggregate demand.

Source: Morgan Stanley Research

Helen Qiao, (852) 2848-6511, [email protected]; Yuande Zhu, (852) 2239-7820, [email protected]; Ernest Ho, (852) 2239-7818, [email protected]

24

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

AxJ Economics Risk-Reward View What’s in the price?

Investor Debates/Themes  

Will concerns over funding risks escalate? Will policy makers initiate tactical stimulus measures to offset the growth weakness?

Base Case / Thesis

2012 GDP: 6.8%

The recent run of data on both the domestic and external fronts has remained weak. While we do expect policy makers to initiate tactical stimulus measures such as policy rate cuts, we remain concerned that the risks to the growth outlook are skewed towards the downside.

Signposts

 We believe deleveraging by European banks will present a challenge to Asia, keeping domestic cost of capital higher for longer. If the funding environment deteriorates, we believe India, Indonesia and Korea will face currency depreciation pressures on the back of funding risks.  We expect policy makers to initiate tactical stimulus measures such as policy rate cuts. In addition, we believe policy makers need to enact reforms to boost domestic demand on a structural basis, especially in China and India.

 Bull Case

2012 GDP: 7.3%

We believe the key drivers that can influence our base case AXJ GDP growth forecasts positively would be an upside surprise in exports and/or if domestic demand proves to be resilient, without a sustained rise in commodity prices.

 Bear Case

2012 GDP: 6.0%

We believe there are three key downside risks to growth: (1) the possibility of a disorderly deleveraging risk scenario emerging, (2) risk of fiscal tightening in the US which will further impact external demand and (3) if domestic demand fails to re-accelerate to offset the weak external environment.

Key Indicators

AXJ Real GDP Growth – Bull, Base, Bear Case Scenarios 2010A

2011E

2012E

2013E

7.3

7.9

6.8

7.5

Bear

6.0

6.3

Bull

4.3

4.2

4.3

4.1

Bull GDP

CPI

Base

Base

9.3

5.1

7.5

5.8

4.3

3.5

Policy Rates (EOP)

5.1

6.1

5.6

5.6

CAB (% of GDP) Fiscal Balance (% of GDP)

4.1

2.6

2.3

2.3

Bear

-3.2

-2.8

-3.1

-2.7

Chetan Ahya, +852 2239 7812, [email protected]

10.8

10.8

AXJ GDP Growth (%) Bull Base Bear

9.8

5 July BNM’s Monetary Policy Meeting 11-18 July Singapore’s 2Q12 GDP 12 July BoK’s Monetary Policy Meeting 12 July BI’s Monetary Policy Meeting 13 July China’s 2Q12 GDP 25 July BoT’s Monetary Policy Meeting 26 July Korea’s 2Q12 GDP 31 July Taiwan’s 2Q12 GDP 31 July RBI’s Monetary Policy Meeting

9.3

8.8 7.9 7.8

7.5

7.3

7.3 6.8

7.5 6.8

6.5

5.8 2007 2008 2009 2010 2011 Source: Bloomberg, Morgan Stanley Research.

6.0 2012E

6.3 2013E

25

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Brazil / Latam Economics Risk-Reward View Investor Debates

What’s in the price?

 After hiking by 175bp last year, the central bank made a u-turn and started cutting in August, totaling 400bp of cuts so far. The central bank picked up the cutting pace in January and March, but indicated that any further move should be done with “parsimony”.  Investors are debating what is driving policy, and how far the BCB go, given how dovish it has been so far.

 Markets are pricing that the BCB will cut rates until 8.00% and start hiking by early 2013.  We expect that the central bank will stop cutting at 8.25%, but we believe that, despite inflationary pressures, it will only hike by late 2013. We are concerned that more inflation is likely and that the policy actions may actually boost uncertainty and damage growth prospects.

Base Case / Thesis

2012 GDP: 2.7%

The Growth Mismatch is coming home to roost. Over the past two years, Brazil has watched as a multi-decade strong currency has boosted consumer purchasing power, while damaging the prospects for local output. Although we are seeing a pick-up on demand, output growth has been more muted. We believe it is due to a structural homegrown problem and also the slower-than-expected recovery in the Chinese economy. Indeed, we are concerned that the principal impact of stimulative policy has been to boost demand (which never suffered as much as output) and to restart the Growth Mismatch − demand outstripping supply. Even though signs of improvement in the economy are now apparent, the central bank has been easing − we suspect in an attempt to push back on currency appreciation. The result is a boost to consumer spending and inflation remaining well above the central bank's target of 4.5%. 2010

2011

Bull

CPI

Policy Rates (EOP)

 Bull Case

 Bear Case

2012E

2013E

10%

3.4

8%

Bear

2.0

2.2

6%

Bull

5.9

6.7

4%

5.3

6.2

2%

Bear

5.0

5.5

Bull

8.25

10.00

8.25

10.00

7.5

5.0

2.7

July 11 Brazil – Monetary Policy Meeting July 12 Chile – Monetary Policy Meeting July 12 Peru – Monetary Policy Meeting July 20 Mexico – Monetary Policy Meeting

6.5

August 8 Brazil – IPCA (July) August 22 Brazil – IPCA-15 (August)

10.75

11.00

7.50

8.00

August 29 Brazil – Monetary Policy Meeting

0% Bear Base

-2%

Bear

July 6 Brazil – IPCA (June)

July 27 Colombia – Monetary Policy Meeting

(%Y change)

2.7

Base

June 29 Colombia – Monetary Policy Meeting

July 20 Brazil – IPCA-15 (July)

4.2

Base

2012 GDP: 2.0%

Brazil suffers more as the globe takes a turn for the worse, even while avoiding a full-blown 2008-style crisis. The central bank reacts quickly with 150bp of rate cuts as inflation reverts closer to the center of the band.

3.5

Base

2012 GDP: 3.5%

Brazil’s GDP could strengthen further, thanks to better global demand for its commodity-based exports due to more robust Chinese demand, the reversal in the slump seen in Euroland and the US. In that scenario, the currency likely remains strong as does domestic demand and inflation − creating tension if the central bank keeps easing.

June 21 Brazil – IPCA-15 (June)

Brazil: Real GDP Growth

Key Indicators

GDP

Signposts

Bull -4% 2004

2005

2006

2007

2008

2009

2010

2011

Source: Morgan Stanley Latam Economics estimates

Gray Newman, (212) 761-6510, [email protected]

2012

August 31 Brazil – GDP (2Q)

26

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

India Economics Risk-Reward View Signposts

Investor Debates/Themes

What’s in the price?

Near term  Is market underestimating the macro stability risks?  Is market underestimating the duration of growth slowdown?

 We believe that persistent bad growth mix of high government spending and declining private investment has fed back into high current account deficit, persistent high inflation and loan-deposit ratios near all-time high. With growth maintaining a downtrend, there is rising hope for quick monetary policy action supporting the growth outlook, but we believe the current stagflation type environment is implying that the low growth environment will stay for longer before we see meaningful decline in inflation below RBI’s comfort zone.

Base Case / Thesis

2012 GDP: 5.7%

A deeper and longer growth slowdown ahead: We believe that the persistent bad mix has reached its limits with growth maintaining a downward trend. Indeed, the GDP data for QE ending Mar-12 confirms our view that a stagflation-type environment is emerging in India. With policy-makers continuing to delay action to address the unsustainable bad mix of growth, we now think that GDP growth is likely to face another leg down. Looking ahead, we expect this stagflationtype environment to continue over the next three quarters. We therefore expect: 1) the depth of the growth slowdown is likely to be more than consensus expects; 2) the duration of the slowdown will also be longer; and therefore, 3) the banking sector is likely to be impaired significantly.

Key Indicators

 Bull Case

2012 GDP: 6.3%

We see bull case scenario growth for India at 6.3% in 2012, assuming a sustained improvement in global macro environment without a persistent rise in commodity prices, acceleration in pace of structural reforms from the government and faster revival of investment sentiment.

 Bear Case

2012 GDP: 4.8%

We see bear-case scenario growth for India at 4.8% in 2012 which could arise due to (1) deteriorating global growth leading to full-blow recession, (2) increasing commodity prices dampening growth prospects, and (3) weaker private investment recovery.

June 29 Balance of Payments for QE Mar-12 July 12 Industrial Production for May July 16 WPI Inflation for June July 31 RBI Monetary Policy Review Next 6 Months Policy announcements on (1) boosting investment activity; (2) divestment of the government’s stake in SOEs; and (3) address funding risks

India’s Real GDP Growth: Bull, Base and Bear 11

2010

2011e 2012e

Bull

CAB (% of GDP)

5.7

6.5

9

Bear

4.8

5.5

8

Bull

7.6

5.8

8.3

6.5

9.3

7.7

6

Base

5

Bear

8.2

12.1

7.5

8.9

Bear 6.25

8.50

7.25

7

-3.2

-3.3

-3.8

-3

-7.6

-8.7

-8.2

-7.4

Fiscal Balance (% of GDP)

Percent

7.2

Base CPI Policy Rates (EOP)

10

6.3

Base GDP

2013e

Chetan Ahya, +852 2239 7812, [email protected]

9.8

7

9.5

Bull

7.4

7.7

7.2

8.2 7.5 6.3 5.7

6.5 5.5

4.8

4 2006

2007

2008

2009

2010

2011 2012E 2013E

Source: Morgan Stanley Research; E = Morgan Stanley Research estimates

27

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Russia Economics Risk-Reward View Signposts

Investor Debates

What’s in the price?

 Will a Putin presidency now accelerate reforms, e.g., anticorruption and privatization?  Will Russian growth accelerate or slow in 2012?  How would Russia be affected by a fall in the oil price?

 Consensus sees GDP growth around 3.5%Y in 2012. We see 5.0% this year, slowing to 4.0%Y next year. Maintaining this rate into the medium term will require progress on the modernization agenda.

Base Case / Thesis

2012 GDP: 5.0%

If the oil price stays at US$100/bbl or above (our base case), we stick to our cyclical upturn call of 5% growth, tightening policy and a strong RUB. We see consumption accelerating, thanks to the Budget 2012 pre-election fiscal package, and investment picking up in the second half, following formation of the new government and clarification of policy. With the new monetary policy framework, we see inflation at 5.0% by end-2012. Russian political risk, following the protests against alleged falsification of the Duma elections, gradually subsided. We see the CBR remaining on hold until the autumn, and focusing on providing liquidity to prevent domestic rates rising sharply but tightening in late 3Q, as the July tariff increases and a tightening labor market support a rise in inflation.

Key Indicators 2011

Bull Base

4.3

4.3

Bear Bull CPI

Policy Rate

2012 GDP: 5.2%

Stronger commodity prices could boost short-term growth.

 Bear Case

2012 GDP: 4.8%

The main risks to 2012 growth are weak external demand, an increase in capital flight due to contagion on international financial markets and political uncertainty. In our bear case, in which a disorderly ‘European Divorce’ pushes the oil price below US$80/bbl in the face of OPEC resistance, we see contraction and a weak RUB, likely triggering a major policy response.

Domestic Demand Supported by Fiscal Stimulus 2010

GDP

 Bull Case

40

2012E

2013E

5.2

4.2

5.0

4.0

4.8

3.5

0 -10

30

%Y

MS forecast

20 10

7.0

7.0

5.0

6.2

Bear

4.8

5.5

Bull

6.00

6.00

5.75

5.75

Real GDP Fixed investment

5.50

5.50

Source: Rosstat, Morgan Stanley Research

Base

Base Bear

3Q-2012 - New Putin pace of reforms - Progress on corruption and political liberalization after the elections

6.9

8.5

5.25

-20 -30 -40 1Q-01 1Q-02 1Q-03 1Q-04 1Q-05 1Q-06 1Q-07 1Q-08 1Q-09 1Q-10 1Q-11 1Q-12

HH consumption Import

Export

Jacob Nell, (7495) 287 2134, [email protected]; Alina Slyusarchuk, (44) 20 7677-6869, [email protected]

28

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

US Rates Risk-Reward View Investor Debates

What’s in the price?

Trades

 What does the extension of Maturity Extension Program (which we call MEP2) mean for the yield curve?  What further steps will the Fed take if economic data disappoints and financial conditions tighten?  Which catalysts (below) should investors pay attention to?

 The announcement of MEP2 has modestly flattened the Treasury yield curve. Additionally, the liquidity and backstop measures by European officials have reduced event risk, in turn decreasing volatility, the mortgage basis and Libor spreads. Long-term inflation expectations have remained anchored, although short-term inflation data has declined.

• Treasuries: We like roll down trades in the 3-to-7 year sector. Enter long duration positions in 7s for the most roll down; alternatively go long 3s-5s for a more cautious stance.

Base Case / Thesis

 Bull Case

10y 1.90%

The upcoming fiscal cliff, uncertainty around US elections and policies, and the overhang of the European situation all weigh on our outlook. Balanced against these risks is the possibility of additional Fed action should economic data deteriorate. The recent extension of the Maturity Extension Program, which we term MEP2, has reduced the probability of any Fed action until the program matures at the end of 2012. As a result, we believe rates will remain rangebound in the near term, and we look for significant changes in economic data to revise our outlook. Our recommended trades center on a low-volatility, range-bound environment.

Level (pt)

Our bull case assumes that financial conditions tighten over the next six months. As a result, the market would extend the first Fed hike by six months. In such a case, we would expect term premiums to compress also due to anticipated Fed purchases and flight-to-quality flows into the Treasury market.

 Bear Case

UST 10y 2.20%

Our bear case assumes financial conditions ease over the next six months. This easing would cause term premiums to rise above our base case forecast. In addition, the market would shorten the time until the first interest rate hike – causing expectations of future short-term rates to rise as well.

• Spreads: We recommend 5-year spread wideners as a hedge against a possible deterioration of fiscal conditions in Europe. • Volatility: The passing of recent risk events with a muted market response is bearish for vol. We recommend trades that express a bearish gamma view. • Mortgages: We still see potential for policy to increase demand for MBS. We are long the MBS basis.

Catalysts

2.50 2.00 FC’s tighter as economic situation worsens

1.00

Tighter

1.50

What we're watching

Market Inflection Points

Inflation

Should inflation expectations continue to decline, we expect the Fed to enact another round of asset purchases. Alternatively, if inflation expectations rise, we expect back-end yields to rise and the curve to steepen.

MSFCI

The Morgan Stanley Financial Conditions Index (MSFCI) tracks the level of financial conditions based upon short rates, long term rates, equities, and the dollar index. Given that Fed policy is largely driven by the Fed’s view of financial conditions, we monitor this to anticipate future policy.

Unemployment

Economic data, primarily the NFP report and the unemployment rate, will be key factors in estimating the pace of the recovery. We monitor this data to gauge the potential for additional Fed action.

0.50 0.00 Easier

-0.50 -1.00 -1.50 Jun 11

UST 10y 1.50%

• Inflation: We are not constructive on shorter-dated inflation, and expect the breakeven curve to bull steepen. We recommend entering 5s/30s inflation breakeven steepeners.

Sep 11

Dec 11

Source: Morgan Stanley Research

MSFCI

US Interest Rates Strategy Team

Mar 12

Jun 12

29

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Europe Rates Risk-Reward View Investor Debates

What’s in the price?

Trades

 Will the ECB respond to renewed Spain & Italy widening with renewed SMP buying? Would it be effective?  Will Spain get a loan from ESFF/ESM?

 1year EONIA prices 50% chance of cut in Deposit Rate to zero

Rates:

Base Case / Thesis: Sovereign risk post-LTRO constrains Bund yields •

Bunds appear to be nearly 100bp expensive vs. traditional valuation models, but this is explained by their “flight to safety” premium. And they are no more expensive than during the 2005-07 “conundrum” period. We favour staying long 10-year Bunds on 2s10s30s: with 2s near 0%, 10s richens on “flight to safety”; while positive carry supports the position Beyond the range, the tail risks appear to be more to the downside for Bund yields, as the path to fiscal sustainability for all euro area sovereigns remains subject to considerable risks

• •

Change to Pension Regs Have Steepened Curve

 CDS 5y cumulative default probability (40% recovery): IE 45%(44) , PT 56%(62), SP 40%(37), IT 37%(35).

 Bull Case

10y Bund to 1%

“Flight to safety” has taken 10-year Bund yields to all-time lows – and a further rally if the euro area breakup risk becomes greater therefore cannot be ruled out. 10-year JGBs yield below 1%: that could be possible for Bunds too.

1s2s EONIA steepener Long 10s on 2s10s30s Neutral duration Spreads: Long contingent bearish Bund asset swap spread narrower struck 25bp OTM Sell France or German CDS basis France 2s10s flattener

 Bear Case

10y Bund to 2.20%

If euro break-up risk recedes, and economic growth exceeds expectations and inflation stays “sticky” above the target, ECB rate cuts become less likely and the “flight to quality bid” for Bunds could fade, causing a cheapening above 2.20%

Long low coupon vs. high coupon in Greece, Ireland, Portugal, Spain, Italy, France (non-linear exposure to spread widening)

Catalysts

45 40

GBP 10s30s

35

What we're watching

Why it matters

Hollande/Merkel

The combined stance of the German & new French governments is always important & would be crucial to the credibility of a “firewall” around the euro area if Greece were to leave the euro area

Spanish banks

Market was underwhelmed by Spain’s latest bank recapitalisation proposals: maybe further measures to come

Spread (bp)

30 25 20 15 10 5 0 Jun-11

Sep-11

Dec-11

Mar-12

Jun-12

Source: Morgan Stanley Research

Laurence Mutkin +44-207-677-4029, [email protected]

30

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

UK Rates Risk-Reward View Investor Debates    

Will the MPC extend QE2 in the future? Will they cut the Bank Rate? Will QE include private sector assets? Will the economic slowdown lead to more borrowing? Will the UK keep its AAA status?

Base Case Thesis - Growth Lower, CPI Lower, More QE in July/August The MPC judged that the upside risks to inflation have lessened and downside risks to growth have grown. Risks to UK and global activity from the Euro area have intensified. We expect the MPC to do £50bn more QE in July. Economic growth is likely to improve in late 2012 and 2013 as the eurozone gradually picks up, with inflation remaining above target in 2013. The MPC will raise rates 3 x25bp in 2013. Gilt yields will begin to price this in during 4Q12 with the front end of the curve underperforming.

10y Gilts tightening to Bunds

What’s in the price?

Trades

 50% chance of a 25bp cut by November  First rate hike H1 15  QE expectation: total spend of £375bn

Short – Short Oct SONIA and Sept 12 Short Stg Short 2y Gilts vs. Schatz UKT 5s10s flatteners Long UKT 20y a/s spreads

 Bull Case – Europe sov debt crisis deepens, UK economy goes deeper into recession, MPC accelerate asset purchases and possibly cuts Bank Rate

Long 6m into 5y ATM payer vs. 50bp OTM payers

10y yield fall to 1.4% and 10y gilt yields trade to tighter to bunds

Bear Case – EU tensions ease, UK growth strengthens and inflation rises Market begins to anticipate rate rises in 2013, causing a selloff led by the 5-year sector. 10y yield rises to 2.50%

Catalysts

80 70

10y Spread

Spread (bp)

60 50

What we're watching

Why it matters

July MPC Meeting

Will they vote to extend QE?

40 30 20 10 0 Jun-11

Sep-11

Dec-11

Mar-12

Jun-12

Source: Morgan Stanley Research

Anthony O’Brien +44-207-677-7748, [email protected]

31

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

EM Fixed Income Risk-Reward View Investor Debates

What’s in the price?

Trades

 Will EM bonds trade like “risk” or risk-free assets?  Is there scope for additional monetary policy easing than what is priced in?

 EM sovereign spreads have tightened by 60bp since the beginning of June.  EM local rates starting to price in selective and moderate easing across EM countries, but further deterioration in growth conditions may call for further easing.

Credit

 Bull Case

Local markets

Base Case / Thesis

CDX EM: 250 bps

After weeks of uncertainty, the Greeks have voted in favour of keeping the country in the eurozone; this has removed to a large extent a major systemic risk weighing heavily on risk appetite. Although the market reaction has been quite muted to far, we believe there is still room for spread compression in the very short term, although quite limited. In rates markets, we expect curves to continue to steepen as the market prices in more front-loaded monetary easing and higher prospective inflation. The risk is further depreciation in EM currencies, which may lead to a quick pricing-in of inflation premia.

EM CDX Spread (bps)

The ECB would resume providing liquidity to the market via LTRO or more standard QE measures. This would give another boost to spread compression. EM rates would bear flatten in this case.

 Bear Case

360 340

The situation in Greece/Spain deteriorates, and/or global economic growth disappoints, triggering another bout of volatility in the credit market. Although LTRO measures have eased funding stress for now, we believe the fundamental problem remains, which is the very high level of indebtedness combined with slow economic growth.

283

240

250

220

Receive CLP 2y vs. Pay AUD 2y SAGB R157/R186 Flattener Buy OFZ 03/18, Sell RF 18 RUB Pay 2y TRY-USD ccy swap

The market continues to underestimate the level of monetary easing relative to the level of monetary easing that our economists anticipate from EM central banks. Recent falls in the price of oil will help too. Some greater stability in exchange rates will however likely be required.

DM

Prospect of QE by DM central banks may intensify market anticipation of higher inflation in EM, and this would be readily priced in to rate (and currency) markets. Pricing out of QE may adversely impact the back end of EM rate curves, consistent with our call for steepening.

Capital flows

A resumption of strong inflows into EM-dedicated fixed income funds would help to build a stronger foundation for a durable rally in EM markets. Volatility in core-market yields and/or sovereign risk concerns 32 in DM may lead to periods of outflows and with it selling pressure.

200 180

70%

2s10s MXN Flattener vs. USD 2s10s Steepener

Monetary policy

270

260

F eb-12

DI Jan’13xJan ’14 1x2 Receiver Spread

Why it matters

300

90%

Receive CLP 1y

What we're watching

320

Oct-11 N ov -11 Jan-12

CDX EM: 300 bps

Sell Turkey 5y CDS vs. Buy Russia 5y CDS

Catalysts

EM CDX spread may tightened by another 30bp

280

CDX EM: 230 bps

Buy Indonesia 5y CDS vs. Sell South Africa 5y CDS

M ar-12 M ay -12 Jun-12 30% confidence interv al

Source: Morgan Stanley Research, Bloomberg

Morgan Stanley EM Fixed Income Strategy

Aug-12 Sep-12

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

G10 Currency Risk-Reward View Investor Debates

What’s in the price?

Trades

 Will European policy-makers establish a credible plan to stabilize the sovereign debt, banking and growth outlook?  How much will Chinese policy-makers act to stimulate their economy? Will it be enough to offset DM weakness?  Will the Fed take any further easing measures in the runup to the election?

 EUR/USD 4Q12 forecast: 1.19, forward 1.32  USD/JPY 4Q12 forecast: 78.0, forward 80.5  GBP/USD 4Q12 forecast: 1.53, forward 1.59

1)

Sell EUR/JPY

2)

Sell EUR/USD

3)

Sell GBP/USD

Target: 1.24  Bull Case

Short EUR/USD

EUR remains mired in political uncertainty and soft economic growth. While the Greek election reduced the tail risk of an imminent departure, ongoing structural problems remain. Spanish and Italian yields are still at unsustainable levels and European banks require additional capital to boost confidence. Meanwhile, our European economists expect the ECB to ease monetary policy as core economic data deteriorate.

A comprehensive and credible roadmap from European policy-makers would boost EUR, in our view. Specifically, we think a European Redemption Fund, if employed, would significantly reduce peripheral yield spreads and attract inflows to Europe. Specific plans on banking and fiscal integration would also renew faith in the common currency.

It is not just European, but global growth which has slowed in recent months. We think investors will be cautious and seek the relative safety of USD. Following the FOMC’s decision to extend Operation Twist, we are less concerned that Fed action will weaken the greenback. Indeed, even if the Fed were to engage in QE, we think there are diminishing returns to its power to cause a USD depreciation.

A worst case scenario would involve a Greek exit, prompted by failure to successfully negotiate and meet Troika requirements. The perceived irreversibility of the euro would then be compromised, leading to deposit flight across the European periphery and emergency procedures from the ECB. Large increases in liquidity would support our trade.

Bear Case

Italian and Spanish Yields Are Unsustainable 7.5

Italy

7

Catalysts What we're watching

Spain

6.5

European summits

The market reaction to this week’s Eurogroup/ECOFIN meetings and next week’s EU council will be key. Investors expecting a comprehensive plan to resolve the eurozone’s debt, banking and growth problems are likely to be disappointed, in our view. But progress toward a European Redemption Fund could cause a EUR supportive risk rally.

Global growth

Over recent months, economic data have slowed across the world, including in EM. With limited flexibility in DM monetary and fiscal policy, further weakness in global growth could lead to broad USD strength.

China’s policy response

This month China eased key policy rates for the first time since 2008. The extent to which this monetary easing continues and is augmented with fiscal stimulus will go a long way in supporting risk sentiment and high-beta currencies. 33

6 5.5 5 4.5 1/1/12

2/1/12

3/1/12

4/1/12

5/1/12

Source: Bloomberg, Morgan Stanley Research

6/1/12

Why it matters

Hans Redeker +44 207 425 2430, [email protected]

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

EM Currency Risk-Reward View Investor Debates     

How much more disorderly can the EMFX moves be? Are we setting up for a sustained rally in EMFX? What can trigger a turn around? How positive is the low positioning, really? Will funding market stress get worse?

Base Case / Thesis

1% depreciation

What’s in the price?

Trades

 USD/CNY 1Y NDF outright at 6.41, compared to our 4Q12 forecast of 6.30  The EM currency market continues to price increased pressure in Europe – reflected by coincident moves between USD/EM and funding stress indicators, and a weaker global growth outlook.

Sell EUR/MXN

 Bull Case

Buy MYR Call Spreads Sell SGD/PHP 12m NDF For our weekly trade ideas, see Global EM Trade Radar, June 18

4% appreciation

Our bearish view on EM currencies has played out well, year-to-date, however we see the risk/reward of bearish strategies as fading. Indeed we recently changed our outlook on the market from reduce to neutral, (see Global EM Investor: Still Risks, but Better Priced, June 1, 2012). While the FOMC did not satisfy market expectations on QE3, we take positives from the policy response in China and other EMs. In addition, our EM Funding Stress Index (FSI) has shown signs of stability, thereby limiting downside in EMFX. From a technical perspective we believe investors are underweight EM and our momentum indicators suggest currencies are in neutral territory (after successfully identifying overbought USD previously). Trend weakness seen in recent months also leaves valuations better placed. This all argues for a more constructive stance, however a weak fundamental outlook and heavy event risk in Europe keeps us from turning outright bullish. As such we avoid heavy directional exposure.

Should European policy makers undertake additional action to support the European periphery’s bond markets / banks, or the ECB / Fed provide additional monetary stimulus (as was indicated as an option in the latest FOMC), then we may see meaningful currency appreciation. Specially given the extent of year-to-date moves in USD/EM, and light investor positioning.

EMFX Momentum in Neutral Territory

Catalysts

Short-Term Aggregate Momentum Index (SAMI)

What we're watching

Why it matters

European Politics

Political developments in Europe have continued to dominate headlines, and dictate moves in EM currency markets. The relationship between the new Greek government and Germany, and progress made on the Spanish bank bailout will act as key drivers to EM currencies.

Global macro data

Global macro data has started to show weak signals, with growth in EM economies starting to disappoint. In addition, our US economists think that the data will trend lower. The market may continue to price in further monetary stimulus from DM central banks – if little is delivered, EM currencies are likely to weaken further.

100 90

103 O verbought

 Bear Case

101

80 99

70 60

4% depreciation

Europe remains the wild card. Should we see policy inaction in Europe and subsequent stress in our funding stress index, then pressure on EMFX would rise. Also, if we see EM growth continue to deteriorate, then capital inflows may provide less support to EMFX than we have anticipated.

97

50 95

40 30 20

93 O versold

91

10 0 Jun-11

89 Sep-11 Dec-11 USD/EM Momentum (LHS)

Mar-12 Jun-12 USD/EM (RHS)

Source: Bloomberg, Morgan Stanley Research

Morgan Stanley EM FX Strategy

34

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

US Equities Risk-Reward View Investor Debates

What’s in the price?

Trades

 Economy & the Fed – Will investors extrapolate recent weakness in US economic data, and what is the impact of Fed stimulus on equities?  Corporate profitability – How much more can Corporate America expand margins, and what is the path of earnings in 2H12 and 2013?

 The S&P 500 is trading at roughly 12.8x 2012 consensus earnings of $105.84. The consensus expects earnings to grow 8% in 2012 and 12% in 2013 − above the long-term average of 7% growth.

Themes:

Base Case / Thesis

 Bull Case

2. ‘Moderate’ Quality over both High Quality and Junk – In periods of neutral to modest risk-aversion, owning a somewhat lower-quality (second quartile) portfolio has historically been the best approach to maximizing return.

S&P 500: 1214

S&P 500: 1500

Our earnings estimate for 2012 is 2% growth, followed by -1% growth in 2013. Our base case 2012 year-end price target reflects a 12.3x multiple on $98.71 of 2013 earnings − the consensus currently expects $118 of earnings in 2013. We assign a 50% probability to our base case.

In our bull case, sustainable economic growth driven by nongovernment forces takes hold, and companies begin to aggressively allocate capital. We assign a 15% probability to our bull case.

Our probability weighted 2012 year-end price target is 1167.

In our bear case, we apply 11.8x to our 2013 estimate of $81.1 to reach 957. Our bear case represents a significant economic slowdown.

 Bear Case

S&P 500: 957

1. Growth over Value – Growth stocks look more attractive than value on price-to-forward earnings, are lower beta, and are more likely to beat consensus expectations than value stocks.

Sector weights: 1. Overweight – Utilities, Health Care 2. Market Weight – Materials, Staples, Technology, Energy, Financials, Telecoms 3. Underweight – Discretionary, Industrials

Catalysts

Our Sector Weights Are Defensive Morgan Stanley Sector Recommendations As of June 2012

5% 4% 3%

What we're watching

Why it matters

Company results

Are companies providing lower earnings guidance? What effect is the stronger dollar having on the bottom line? Is the slowdown in Europe feeding through to results?

Stock ideas

We recommend large-cap, quality-growth stocks with sustainable dividends. Mid-to-small-cap, lower-quality value stocks often lag in riskaverse regimes.

Dividends

The payout ratio of dividend-paying stocks is near a historical low, and managements have been paying themselves more in RSUs than options at a steady pace, making dividend increases increasingly likely.

2% 1% 0% (1%) (2%)

Over we ig hts - U ti li ti es , H ea lth C ar e Mar ket-W ei gh ts - Stap le s, M ate ria ls, Te chn ol og y, E ne rgy, Te lec om s, Fi na nc ia ls Un de rwe ig hts - In du stria ls, D iscr etio na ry

Industrials

Discretionary

Telecoms

Financials

Energy

Technology

Staples

Materials

Health Care

Utilities

(3%)

Adam Parker, (212) 761-1755, [email protected]

Source: Morgan Stanley Research estimates

35

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

European Equities Risk-Reward View Investor Debates

What’s in the price?

Are we close to a resolution of the euro-zone sovereign debt crisis? How severe is the global economic slowdown? Can quality growth stocks continue to outperform value names?

 MSCI Europe is on a consensus 12m forward P/E of 9.8, although this rises to over 11 on our own EPS estimates. We continue to assume that ‘fair value’ equates to a 12m forward PE of around 10 in this cycle. Our CVI and MTI models are in ‘buy’ territory. The Shiller PE is at 11.6.

Base Case / Thesis

 Bull Case

MSCI Europe: 885

‘Muddle through policy with little or no growth’ (14% downside). We assume that the euro-zone economy contracts by 0.3% in 2012, while global GDP grows at 3.7%. Our economic assumptions lead us to forecast an 8% contraction in 2012 EPS followed by a 2% rise in 2013. Although policymakers are likely to be able to stabilise the euro-zone sovereign debt crisis, any rally in stocks is likely to be temporary given the poor medium-term growth outlook. Consequently we continue to prefer defensives over cyclicals and financials. We probability-weight our scenarios as: Bull case =20%; Base case = 45%; Bear case = 35%. Our probability weighted index target for MSCI Europe is 870 (15% downside).

MSCI Europe: 1250

‘Europe resolution, strong external growth’ (22% upside). European policymakers foster a comprehensive solution while the global economy regains momentum, helped by aggressive monetary policy and delayed fiscal tightening in the US. European EPS grows 8% in 2012 and the 12m forward PE rises to 12.

 Bear Case

MSCI Europe: 625

‘No European resolution and global recession’ (39% downside). The euro-zone sovereign debt crisis continues to weigh on markets, with associated loss of confidence producing a global recession. European EPS falls 35% and equities follow as the PE ratio fails to expand into the downturn. The Shiller PE falls below 10.

Trades Sectors: O/W – Telecoms, Healthcare and Materials. U/W – Consumer Discretionary, Industrials and Banks. Themes: 1) Prefer defensives over cyclicals and financials. 2) Buy stocks with a high and secure dividend yield 3) Quality growth for the long-run – Nifty Fifty+. 4) OW core vs. UW periphery. OW UK. 5) Prefer Large-caps to Small-caps.

European Earnings Revisions Have Rolled Over Catalysts 20 15

What we're watching

Why it matters

10

Growth indicators

In a post debt supercycle world the key driver of equities is likely to be the outlook for global economic growth.

Policy response

In this cycle equity markets are highly sensitive to geopolitical uncertainty and policy stimulus. Any policy announcements that are perceived to be an effective contribution to a Euro-zone resolution should prompt multiple expansion.

Corporate margins

Although revenue growth has been stronger than expected in 1Q12 margins have disappointed nevertheless. As the former starts to slow we’d expect further pressure on margins to lead to analyst EPS downgrades.

5 0 -5 -1 0 -1 5 -2 0 -2 5 -3 0 J a n -0 9

J a n -1 0

J a n -1 1

J a n -1 2

Source: IBES, Morgan Stanley Research

Graham Secker, +44 207 425 6188, [email protected]

36

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Japan Equities Risk-Reward View Investor Debates 

Will policymakers inject new stimulus? Is it time to reinvest cash?



What policy events will trigger an upswing to Japan equities?

Base Case / Thesis

2012 yr-end: Topix 890

Our proprietary bond-stock allocation model has switched its preference to equity from bonds for the first time since the March 2011 earthquake. We believe the switch is not merely a reflection of a rebound from post-quake reconstruction demand, but rather signals a turnaround in the longer-term cycle after the global financial crisis of 2008, where Japan has lagged other regions including US and Germany. With GME2, large number of central banks globally are expected to deliver more easing over the next few quarters, including the ECB and in EM China where already cut rates once and we are expecting at least one more cut. We estimate TOPIX PE of 15x with EPS of 60 yen for Dec-end 2012. Dec 2012e:

TOPIX target: Base Bull

1400

Bear ExtBear

Target

What’s in the price?

Tactical Trades

 Manufacturers are now able to make profit at 83 yen against the dollar on average (compared to 106 in 2006) which is not priced in to current valuations in our view

Sectors:

 What’s not in the price: Signs of structural adjustment of manufacturers post global financial crisis finally coming to an end.

 Bull Case

U/W – Other financials, retail trade, air transportation Themes:

2012 yr-end: Topix 1110

BoJ to ease more aggressively while global growth of 4.2% with Japan GDP growth of 2.4%. Trailing PE assumption at 17.9 with TOPIX EPS of 62 yen. Implied upside is 52%.

 Bear Case

O/W – Machinery, Shipping, Transportation Equipment

2012 yr-end: Topix 770

Expected cyclical upturn as we see strong troughing of domestic expectation indices. Low PBR + No dividend paying out growth stock to outperform at those timing relative to high dividend yield strategies

Larger peripheral country or group leaving the Euro, with global growth of 2.7% with Japan GDP growth of 0.6%. Implied upside is 6%.

Catalysts What we're watching

Why it matters

Yen

We believe the yen impacts share price from two sources: 1) Absolute level of strong yen hurting OPM given current corporate structure and 2) Momentum of yen strengthening inducing structural transitions of production and strategy by sacrificing margin on a shorter-term. We believe the negative effect imposed by (2) will be less, assuming that the yen stays at current levels; in our view the market is mispricing this.

BoJ

New members of the Policy Board are more aggressive, but the governor still controls the agenda. Political factors might bring a grand coalition, which would likely pressure the BoJ more. Equities would benefit, from both weaker yen and reduced deflation.

1300 1200 Bull: 1110 (+52%)

1100 1000 900

Base: 890 (22%) Target: 880 (21%)

800

Bear: 770 (6%)

700

ExtremeBear: 650 (-10%)

600 Jul/12

Jul/11

Jan/12

Jul/10

Jan/11

Jul/09

Jan/10

Jan/09

Jul/08

Jan/08

500

Source: Morgan Stanley Research estimates

Yohei Yamada, (81) 3 5424-5923, [email protected]

37

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Asia / GEMs Equities Risk-Reward View Investor Debates

What’s In The Price?

Trades

 Is It time to buy back EM equities after the fall in May?  Has China now begun a major easing cycle?

 MSCI EM Trailing P/B is at 1.5 which is around 20% below the 20 yr average of 1.9x (82nd percentile cheap on 20-yr history) and 10% below MSCI World

 We raised our equity weighting to 10% OW (predefine maximum OW) i.e. zero cash on June 8, 2012 in our bond, equity, cash asset allocation model. Current valuations backtest for returns between 20% and 40% over the following six months. Our preferred areas of country exposure in EM are our OWs of China (A and H), Korea, Russia, Indonesia and Malaysia.

MSCI EM scenario-weighted target price for end2012 is 1210 (+28%)

1 SD above the models fit. Our bull case EPS forecast is US$114 for 2012

Base Case (55%): 1305 for end-2012 (+38%)

Bear Case (20%): 900 for end- 2012 (-5%)

Our base case for 2012 is derived using the MS economics team’s base case forecast. In this scenario we expect 9% USD EPS growth, derived from a four-factor regression model and an exit P/E of 13.0x for end 2012. Our base case incorporates US$ EPS of 100 vs. consensus forecast of $98. Our P/E assumption is derived from the average year-ahead prediction from four quant models.

MS economics team’s bear case is a modest global recession driven by the EU crisis. EM GDP growth would be 4.3% versus 6.0% in the base case. In this scenario, we  At the industry level, we are OW Auto, assume a trailing P/E multiple of 11.2x for 2012 which is Energy, Healthcare Equipments, Real 1SD below our model fit. Our bear case EPS forecast is Estate, Capital Goods and Consumer US$80 for 2012 Services. We also upgraded Materials from Extreme Bear Case (10%): 555 for end-2012 UW to EW

Bull Case (15%): 1700 for end- 2012 (+79%)

(-41%) This scenario would require sequential EU public and private defaults over the next months. We assume a trailing P/E multiple of 9.3x for 2012 which is 2 SDs below the models fit. Our extreme bear case EPS forecasts is US$60 for 2012

Our bull case assumes a swift and convincing solution to Europe’s sovereign crisis and a balanced US medium term deficit reduction plan along with Chinese growth reacceleration and above-consensus earnings growth. In this scenario we assume a trailing P/E multiple of 14.9x which is

Key Indicators to Watch

MSCI EM 2012 Target Price 1,500

Price Targets Dec-11 Jun-12 Dec-12 1200 1305 1355

MSCI EM USD Decem ber 11th, 2006 MS GEMs Strategy Initiation

1,350 1,200 1,050

What We're Watching

China’s 25-basis-point interest rate cut on 7th June is likely a significant positive catalyst for EM equities. After a significant slowdown in April, China’s macro data stabilised in May. Lower inflation has allowed the authorities to start the first interest rate reduction cycle since 2008. We expect further RRR cuts, sequential loan growth acceleration and fiscal measures including NDRC project approvals to drive a significant acceleration in GDP growth through 2H 2012.

Europe Crisis

The formation of a pro-bailout government in Greece is positive and reduces the risk of a near-term eurozone exit probability. EMEA is more exposed to Europe via trade and funding linkages than APxJ and Latam where exposure is relatively limited.

750 600

MSCI EM Benchmark MSCI EM Index Price Target MSCI EM Index Bear Case

Source: MSCI, FactSet, Morgan Stanley Research. Data as of June 20, 2012

Dec-12

Jun-12

Sep-12

Mar-12

Dec-11

Jun-11

Sep-11

Mar-11

Dec-10

Jun-10

Sep-10

Mar-10

Dec-09

Jun-09

Sep-09

Mar-09

Dec-08

Jun-08

Sep-08

Mar-08

Dec-07

Jun-07

Sep-07

Mar-07

Dec-06

Jun-06

Sep-06

Mar-06

Dec-05

300

Why It Matters

China Macro Stance and Macro data

900

450

 Key themes: High Beta stocks to play our bullish Equities view and continue to prefer Dividend Yield and Dividend Growth, Statecontrolled companies and Best Business Models in EM.

Jonathan Garner, +852 2848 7288, [email protected]

38

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

US Corporate Credit Risk-Reward View Trades

Investor Debates

What’s in the price?

 Will concerns about the US fiscal cliff, eurozone stresses, and slowing EM growth push spreads wider?  Will fundamental improvement in credit continues to stall, or begin to deteriorate?

 IG is trading slightly above our fair value estimate, while HY remains wider than fair value.  Lower-quality high yield offers substantial compensation for defaults, above our expectations.  Large-cap Financials spreads may continue to compress due to growth, stress tests, and potential litigation settlements.

Base Case

 Bull Case

Slow but Steady Growth

IG 195bp, HY 570bp. We think credit is the asset class that performs best in a slow-growth environment. A continuation of the ‘muddle-through’ macro backdrop means stable corporate profits and entrenched corporate conservatism, a positive for credit. We expect a mild recession in Europe as our base case, but contagion risks will be contained and volatility across credit markets will remain low. Inflows into HY will continue as investors chase yield. Defaults will remain in check (2.9% for US HY) as corporate fundamentals improve further. The combination of a supportive macro environment, improving fundamentals, a solid technical backdrop, and reduced volatility will continue to drive spreads tighter in lower-quality credit.

Robust Growth Returns

IG 143bp, HY 450bp. US economic growth and corporate earnings surprise to the upside. The new issue market is robust for most credits. Liquidity improves meaningfully as dealers and investors re-risk. Easier financial conditions, rising inflation expectations, and higher risk-free yields provide a better entry point into high-quality credit, while low defaults drive investors into HY.

 Bear Case

Mild US Recession

IG 248bp, HY 1,100bp. European sovereign stresses escalate and Financials deteriorate, pushing the US into a mild recession. Spreads widen materially (at or above 2002 wides) as investors demand more compensation for volatility and deteriorating fundamentals. HY defaults rise to 5.5%, but remain below prior recessions due to strong fundamentals.

We Expect US Defaults to Remain Low vs. Europe Catalysts

Long US IG non-Financial BBB’s – Non-Fin BBBs provide nearly 70% of the sector’s excess return for slightly less than half the sector’s volatility. And there is enough of a spread premium to compensate for peak default rate and ratings migration risks. Focus on front part of curve – Onehalf of the spread can be earned by investing in corporate bonds with 1-7y maturities, consuming less than onethird of the market volatility. For excess return investors, we advocate focusing on the large 3-7y sector. Long High-Beta HY – High-beta HY will outperform as credit spreads tighten and default rates remain in check. Leveraged Loans over BB Bonds – For investors looking to stay defensive, we recommend purchasing loans over BB bonds, as loans trade at a discount to BBs, and are not exposed to rising rate risk.

HY LTM Default Rates - US and Europe 18% US HY

15% 12%

Europe HY

What we're watching

Why it matters

European contagion risk

Our Global Economics team expects a mild European recession, but eurozone sovereign stresses remain on investors’ minds. Spanish bond yields have drawn investors’ attention due to concerns about the impact of fiscal austerity measures on growth.

US fiscal cliff

While our US Economists expect slow but steady 2% economic growth for the next few years, the possible fiscal cliff at the end of 2012 could be a major impediment to growth if not resolved.

Credit volatility and hedging

Investors are once again focused on hedging, as they consider the possibility of a larger pullback in spreads. XOver and CDX HY have widened over 150bp and 100bp, respectively, since their YTD tights.

US MS Forecast Europe MS Forecast

9% 6% 3%

19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12

0%

Source: Morgan Stanley estimates, Moody’s

Sivan Mahadevan (212) 761-1349, [email protected] . Adam Richmond (212) 761-1485, [email protected]

39

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

European Corporate Credit Risk-Reward View Trades

Investor Debates

What’s in the price?

 Is a recession in the price?  What level of defaults are spreads currently implying?  How can investors position for a seemingly binary markets?

 Spreads in CDS and cash bonds have diverged significantly. CDS indices, such as Senior Financials or XOver, have already given back most of their gains from their rally since the start of the year. Cash bond spreads have widened much less from their recent tights.

Base Case

A (Mild) European Recession

Europe gradually moves toward closer fiscal integration over 2012. European growth sees a mild recession, a contraction better than 2008, but worse than 2001, with HY default rates rising to 4-5% in 2012 and 2013. Central bank policy remains loose, given the lack of fiscal stimulus, and both gilt and Bund yields remain range-bound. Volatility declines from current levels, but remains above-average. Key to this is some stabilization in peripheral European growth. Our Economists forecasts call for Spain and Italy to both contract ~2% in 2012, with zero growth in 2013. That outcome is not great, but it does seem manageable at current valuations

Risk Premium to Higher Defaults already Exists

 Bull Case

 Bear Case

40%

40%

38%

Catalysts

Implied Defaults

30%

Worst 5yr Default Rate

25%

Average 5yr Default Rate

20% 15% 10% 5% 0%

10% 7% 4% 1% Main 5yr

5% 2%

CDX IG 5yr

iTraxx Xover 5yr

Non-financials – O/W defensives over cyclicals: Utilities, a defensive, creditfriendly sector trading historically wide to the market, is our largest O/W. Weaker global indicators lead us to cut our O/W in Basic Materials. We see significantly more value in GBP relative to EUR credit. Buy payer spread collars and Super senior hedges: Implied volatility has fallen through the rally, but healthy skew benefits selling deep OTM payers. Buy protection on S9 7yr 22-100 Long S9 Jun-13 0-3%:: 1yr trade with 12%+ yield even after hedging 10 widest names in the portfolio..

What we're watching Depth of recession

Why it matters Our economists already expect Eurozone growth to fall by 0.3% in 2012. The risk is that growth stalls more than expected, and corporates face more severe stress to earnings and cash flow.

Steps towards fiscal integration

Changes in eurozone fiscal governance can create a more acceptable backdrop for more forcible ECB policy, dampening volatility in the sovereign space, and a positive for credit.

Speed of deleveraging

Deleveraging drives continued negative net issuance out of European banks and low net issuance in corporates.

24%

19%

Financials – Move T1 Underweight to Neutral: Adding carefully in high-step Tier 1s: i) which have high coupons and high steps ii) exhibit good relative value versus other Tier 1s; and/or iii) have underperformed.

40%

33%

35%

Things Fall Apart

The eurozone’s sovereigns borrow in a currency they don’t control and without a lender of last resort. Instead of coming together to address this issue, Europe diverges further, pushing for even greater austerity but refusing to commit to greater fiscal union or central bank support. Investor flight and accelerated deleveraging ensue, as does a much deeper recession. European credit breaches its 2008/09 lows.

5yr cumulative default rate 45%

Savings Supercycle

If European officials are able to re-establish confidence in the system then we are left with a secular deleveraging story with striking similarities to Japan. A long-term shift in private sector mentality towards savings should be relatively better for highquality credit (given its effect as a headwind to growth), and supportive of spreads below their 10-year average.

Down to E/W: On March 30, we closed our overweight in European credit, moving to Neutral.

CDX HY 5yr

Source: Morgan Stanley Research, Note: Assumes 35% recovery

Andrew Sheets, +44 20 7677 2905, [email protected]

40

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Asia Corporate Credit Risk-Reward View Investor Debates

What’s in the Price?

Key Themes

 Where is eurozone risk heading and what’s a solution that’s both sustainable and likely?  How will Asia cope with EU deleveraging or funding market stress?  Is the policy cycle in China turning for the better?

 Current Asia IG valuations imply default rates worse than during the Asia financial crisis.  Asia IG spread premium over similar fundamental credit risk in the US is currently an additional 75bp (or 75%) extra spread.

Base Case

 Bull Case

 Spreads: We expect moderately tighter spreads.  Key stance: China credit likely to outperform in the HY space.  Supply: We see significant upside to corporate supply.  Key risk: Eurozone crisis turning into a global funding market crisis.

Muddle Through

(250bp, 60% prob, +4.6% ER)

Sluggish global growth but no recession in the US or hard landing in China and only a mild recession in Europe. Gradually receding inflation pressures allow a moderate policy response, driving spreads back to the middle of the post-crisis range. Asia will still face the challenges of eurozone deleveraging, putting further pressure on credit conditions and creating upside risk to supply. Chinese credit conditions are unlikely to ease materially.

Bear Case

2002-Style Recession

(400bp, 25% prob, -2.9% ER)

Our bear case is a 2002-style US recession, creating meaningful downside to Asian growth. The cost of funding increases but funding markets are still operating. Mitigating this downside are conservative valuations and stronger and more liquid corporate balance sheets.

Asia IG: Expect Moderately Tighter Spreads 800

Spread (bps)

600 500 285

400bp, 25% prob

300

305bp

200

250bp, 60% prob

100

A combination of more reflationary and credible policies in Europe reduces systemic risks meaningfully, allowing the market to focus on the strength of corporate balance sheets, growing savings pools around the world and benefits of fixed income. Asia continues to benefit from an ongoing global asset allocation shift and eventually improving credit conditions in China and trades through this cycle’s tights.

  Extreme Bear Case (800bp, 5% prob, -23.0% ER)

Crisis

Key Trades  HY Corporates: Bullish on China HY, property in particular.  Financials: Cautious on Indian banks.  Duration: Prefer long-dated IG risk.

An insufficient eurozone policy response triggers an accelerated deleveraging event, intense pressures on global funding markets and capital flight. Asian/Chinese policy response, including re-activated FX swap lines, is a mitigating factor but insufficient to prevent spreads retesting the 2008 wides.

Catalysts

800bp, 5% prob

700

400

Japanification

(150bp, 10% prob, +9.6% ER)

150bp, 10% prob

0 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Historical Performance Current Spread Spread Fair Value Source: FactSet, Morgan Stanley Research estimates

Viktor Hjort +852 2848 7479, [email protected]

What we're watching

Why it matters

Downside risks: Funding market stress

The key link between eurozone policy turmoil and Asian credit risk runs through the global funding markets. Asia is far better insulated than other Emerging Markets, but a breakdown would translate into immediate refinancing risk.

Upside catalyst: Easier China credit conditions

Credit growth in China has now stabilized after two years of steady declines. The policy cycle has also shifted into acceleration gear, and may indicate easier credit conditions which would be very supportive for Asia HY. 41

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Securitized Credit Risk-Reward View Investor Debates

What’s in the price?

Trades

 Magnitude and timing of losses in mortgage pools, both residential and commercial.  Uncertainties of cash flows due to loan modifications and lower servicer advances spreading beyond subprime  Resolution of foreclosure related litigation.  Liquidation of legacy positions held in US and Europe

 Despite the many macro uncertainties, investor interest in securitized products remains high. We think that relative to the alternatives, prices of securitized products reflect worse economic outcomes and thus being increasingly seen as the better value proposition given the prevailing low yield environment.

Long 2006-07 CMBX AMs and 200507 AJs both in cash and CMBX

Base Case / Thesis

 Bull Case

In non-agency RMBS, market technicals have been supportive of pricing for most of 2012. The investor demand for large supply (e.g. Maiden Lane auctions) has been unwavering and we have seen prices appreciate or at least maintain their levels throughout these periods. A lot of this can be attributed to the low yield environment; we have seen more investors flock to the high yields in non-agency.

Foreclosure mitigation efforts reduce shadow inventory and strategic default incentives, leading to significant improvement in RMBS collateral performance. Similarly, losses in CMBS pools turn are lower along with uncertainty about remaining duration. In CLOs, the AAA mispricing corrects (tightening of 100 bps) and re-prices the capital structure.

Long CLO BBB versus HY corporates

In CMBS, a re-assessment of base case credit performance and liquidity have driven prices lower. We expect continued collateral deterioration. However, given fundamentals at recessionary levels, double-dip impact likely relatively muted. Given loss expectations, cash/synthetic AMs are compelling. In CLOs, BBB and above tranches have attractive returns that are invariant to a broad range of default and recovery outcomes. Single-A tranches are a “sweet spot”.

Transition Rates: Always Current to Worse

 Bear Case European bank deleveraging leads to significant asset sales that could drive down prices, particularly in non-agency RMBS. Foreclosure mitigation does not reduce shadow inventory and strategic default incentives, leading to extension of durations on non-agency RMBS. In CMBS, loan modifications lead to extension of duration beyond 3 years. Previously optimistic underwater borrowers walk away and maturity defaults increase. Duration extension in CLO mezz.

Long CMBX.4 AJ, short CDX HY Long TRX.II Long CLO single-A versus IG corporates

Long CLO equity, both new issue and legacy Long senior tranches of European CMBS Long senior tranches in UK prime RMBS Private equity investment in distressed single-family real estate funds focused on buy-to-rent strategies Collateralized lending to portfolios of distressed single-family real estate

Catalysts

5%

What we're watching

Why it matters

Potential for policy intervention

Mortgage credit conditions remain tight. Any policy action to expand or further constrain the credit box would be very meaningful for securitized products in general.

Market Technicals

The combination of double-dip fears and eurozone sovereign concerns have led to significant illiquidity and risk aversion. We expect bouts of illiquidity and volatility going forward as market looks more to headlines than collateral performance.

4% 3% 2% 1%

1

1

-1

-1 ar

ay

M

M

n-

11

0

O p tio n A R M s

Ja

0

-1 ov

N

0 S

ep

-1

0

l-1 Ju

0

-1

-1 ar

ay

M

A lt-A

M

9

10 n-

ov

Ja

-0

9

S u b p rim e

N

9

-0

ep

S

l-0

ay M

Ju

9

-0

09

-0

n-

ar M

Ja

9

0%

P rim e J u m b o

Source: Morgan Stanley Research

Vishwanath Tirupattur, (212) 761-1043, [email protected]

42

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

In the United States, portions of this report regarding non-US options are intended for Morgan Stanley’s Institutional Clients only.

Global Credit Derivatives Risk-Reward View Investor Debates

What’s in the price?

Trade Ideas

 What is the bigger risk to credit investors going forward – idiosyncratic or systemic risk?  How valuable and affordable is convexity in the derivatives market today?  Is credit volatility rich or cheap at current levels relative to its realized level as well as other asset classes?

 The cash-CDS basis remains slightly negative in US IG, but has narrowed recently as CDS underperformed cash in the move wider.  Credit curves have steepened recently, with the long end underperforming.  Credit volatility remains elevated relative to equities.

Base Case / Thesis

 Bull Case

After selling off following a Q1 rally, spreads have moved largely sideways of late as markets grapple with a mix of European sovereign stress and weak macro data from the US. The sell-off has thus far had a greater impact on CDS, causing a narrowing of the basis. In the tranche markets, we have seen curve steepening in IG9 tranches with high beta names underperforming. We believe that convexity is valuable in the market today and like short-dated options as hedges in Europe. We also like long equity tranches/mezzanine tranches given low implied correlation levels and as a good micro trade in markets driven by macro news flow.

Growth surprises to the upside and contained sovereign volatility in Europe leads to tighter spreads. As systemic stresses ease, implied correlation moves lower in the index tranche market, and implied credit volatility and downside skew in the options market continue to decline.

TRANCHES: Long Mezzanine Tranche Risk: Mezzanine tranches in certain types of portfolios can benefit from falling dispersion at current valuations. Long Equity Tranches Hedged with Widest Names: Given low correlation, equity tranches offer attractive longs in this environment, especially when paired with single name shorts.

Volatility and Spreads Off their Lows

Tighter spreads, lower volatility

 Bear Case Recession, wider credit spreads, and higher volatility DM recession leads to wider credit spreads, potential stress in the funding markets and further strain on corporate fundamentals with possible defaults. Implied correlation and volatility spike higher and downside skew remains elevated. Credit curves bear flatten and eventually invert at wider spread levels. The cash CDS basis gets more negative.

OPTIONS: Sell Credit Volatility to Fund Hedges in Other Asset Classes: We like selling HY puts to buy SPX puts, selling IG receivers to buy rates volatility and selling iTraxx Main protection to buy EURUSD puts. Buy payer spreads in the US, payer spread collars in Europe: Given the move steeper in skew, we like payer spreads as hedges across CDX IG and HY. We also like CDX IG bearish risk reversals as a large tail hedge.

Catalysts

Vol Levels LTM (Lows, Spot, Highs)

17.2%

SPX

36.8%

14.1% 2.8%

CDX IG

What we're watching

Why it matters

Cash / CDS Basis

The cash CDS basis remains more negative in the US, and has remained positive in Europe. Liquidity, technicals and movements in interest rates can be a key driver of the cash-CDS basis.

Credit Volatility Skew

Downside skew as implied in the credit options market remains steep in iTraxx Main, but has fallen in CDX IG, HY. This is a barometer for tail hedge activity.

Index and Tranche Curves

Credit curves can move around a lot in times of stress and the curve shape will be an important indicator for deciding the optimal maturity at which to implement directional (i.e. long/short) trades.

5.5%

1.5% 11.1%

CDX HY 7.7%

SX5E

20.9% 25.0% 41.7%

18.6% 5.3%

iTraxx Main

8.9%

2.5% 14.5%

iTraxx XOver 7.8%

24.5%

Source: Morgan Stanley Research

Sivan Mahadevan, (212) 761-1349, [email protected]

43

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Crude Oil Risk-Reward View Investor Debates 1) How low can oil go? and 2) Will seasonally stronger demand and Iranian sanctions drive crude higher over the coming months? The consensus view is that Saudi Arabia requires an oil price of $85-90/bbl to balance its budget, which should create a hard floor for prices. We disagree and don’t believe in hard floors. There is no requirement for a country to balance its budget, and concerns about longer-run oil demand and mitigating the euro zone crisis may take priority. Finally, price is not the only factor dictating revenue. Rather, we believe a fall below $90 will start to bring a slow OPEC response and stimulate demand, helping to limit downside to $85-90/bbl. We don’t see a fall to $50-60/bbl, as many fear, unless a full blown economic crisis erupts.

What’s in the price? A decline in the Iranian risk premium and deteriorating fundamentals, both in the OECD and EM, have generated selling pressure since late March. Negative macro sentiment and sluggish global GDP growth is only exacerbating the sell-off. Even so, crude net spec length remains fairly elevated, especially relative to other commodities. With Brent moving firmly into contango for the first time since early 2011, this remaining length may be flushed out of the market. Moreover, the weaker structure is indicative that the market is oversupplied globally (estimated between 1.0 and 1.5 mmb/d), but in the Atlantic Basin in particular. As a result, without a large cut in OPEC production, inventories will continue to build well above normal. Given macro concerns and the looming start of the EU’s Iran sanctions, the market seems to coming to the view that any reduction in OPEC production will not meet what will be required to balance the market.

Base Case / Thesis

2012 = $105/bbl (Brent)

Deteriorating macro only exacerbating weaker fundamentals and easing geopolitical concerns. Oil prices are trading below $100/bbl for the first time since Oct ’11 (Jan ’11 on a sustained basis). We believe softening Iranian tensions and deteriorating fundamentals are responsible for the majority of the correction. While the macro has clearly contributed to the recent decline, oil prices started their descent in late March and April, well before renewed concerns about Europe and China. Fundamentals weaker than OECD inventories suggest. While total observable inventories built less than normal in April and May, we estimate that global inventories built by a substantial ~50 mmb during April. In May, OECD crude stocks built 17.8 mmb above normal as OPEC production at 31.9 mmb/d neared multi-year highs and US production continued to surprise to the upside. Product stocks drew counter-seasonally in May on elevated US product exports to Latin America and Europe, but product days of supply remain adequate. Weakening curve structure in the face of increasing refinery runs and low product stocks only corroborates our view. Downside risk remains; a fall to the low $90s is possible. 3Q12 will not be a repeat of 3Q11. Beyond the macro risk, we continue to see inventories building above seasonal norms into 3Q12, challenging price and curve structure. Relative to 2011, the 3Q supply picture is much improved and seasonal demand drivers are more restrained. We see signs of possible Saudi production restraint, but our balances show OPEC would have to cut production by a large 1.15 mmb/d if inventories are to follow seasonal norms in 3Q. Lastly, new signs of EM weakness (China in particular) present downside risk to our global demand growth forecast of 719 kb/d. Prices will continue to fall if the macro deteriorates, but the response to lower prices should help create a soft floor for crude. If Brent prices do fall towards $90/bbl, we believe that OPEC will start to dial back production. Moreover, lower prices should start to elicit a demand response, gradually helping balances return to equilibrium. Beyond these factors, there is also the potential to shut-in marginal production and reduce biofuel production, but we view these levers as low probability events unless prices move much lower.

OPEC Cut Needed to Mitigate Inventory Builds (QoQ Δ in inventories, kb/d) 1.4

0.7

0.0

-0.7 Q1 2012 - 150 kb/d cut

Q2e

Q3e

2012 - 575 kb/d cut

Q4e 2011

5Y Avg

Source: IEA, Morgan Stanley Commodity Research Note: Cuts are assumed in July and result from the Iranian embargoes

 Bull Case

2012: $125/bbl

Renewed geopolitical risks reignite supply disruption fears. In particular, if Iranian threats to close the Strait of Hormuz are realized, prices would soar owing to the lack of alternate routes available to transport the 15-17 mmb/d of crude flowing through the strait.

 Bear Case

2012: $85/bbl

Greater economic woes. DM policy errors and debt contagion from Europe spread globally, damaging an already weak economy. While not a repeat of 2008, we believe global oil demand will be flat YoY with large OECD declines. OPEC is slow to respond, leading to large inventory builds.

Catalysts What we're watching

Why it matters

US/Euroil/China/Japan Fundamental Data

Provides timely confirmation of demand developments in the OECD – weekly for the US and Japan, monthly for Europe and China. In addition, inventory level updates help us evaluate our forecasts for supply and demand.

Physical Markets

The structure of the forward curve, as well as crude and product prices in the cash markets, provides color on what the fundamentals are saying – there is little influence from speculators in the cash markets.

The Middle East: OPEC and Geopolitical Tensions

Falling prices could trigger an OPEC cut, which is needed for inventories to follow seasonal norms. Furthermore, tense P5+1 talks with Iran and the threat of military action could quickly reignite supply concerns if negotiations fail.

Hussein Allidina, (212) 761-4150, [email protected]

44

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Cross-Asset Volatility Volatility Remains Low and Skew High As Markets Retrace Equity vol low, skew moderating

Equity volatility remains low, but macro risks remain, keeping downside skew elevated.

Credit vol similar to equities

Credit volatility is at similar levels to equities.

US Rates

Given the recent decline in correlations, we like shorting curve vol. We recommend selling 3m 10s/30s curve caps against buying 3m30y payors, regression weighted. This structure has an excellent historical entry point, attractive risk-reward, and slight positive carry.

FX

Low yields and rising volatility may work against the high-beta currencies. Our analysis finds that potential carry returns within the G10 are at historically depressed levels, while the low level of yields globally will keep investors sensitive to any increases in volatility.

Asset Class Equities

Credit Rates FX Commodities

Asset SPX SX5E HSI IBOV CDX IG iTraxx 1y US Rates 10y US Rates EURUSD USDJPY Oil Gold

Current Vol 17% 25% 21% 23% 54% 69% 34 bps 87 bps 11% 9% 33% 19%

2006-2007 Change in 3m Vol 3m Imp Vol 3y Average since Sep 30 2011 Percentile 13% -18% 23% 15% -13% 62% 17% -15% 41% 27% NA NA 61 bps 67 bps 7% 7% 29% 19%

-12% -26% -27% -21 bps -25 bps -5% -2% -16% -12%

Change in Skew 3m Skew (90Change in since Sep 30 110) 3y Spread/Price since 2011 Percentile Sep 30 2011 0% 88% 20% -2% 21% 1% -4% 77% 11%

32% 33% 47% 10% 19% 12% 5% 51% 44%

-2% -4% -5% -13 bps 4 bps -1% -2% -1% 0%

50% 40% 40% 29% 86% 73% 10% 92% 74%

9% -26 bps -20 bps 4 bps -8 bps -5% 3% 1% -1%

Note: Rate volatility is in normalized basis points, credit volatility is volatility of spreads, and all others are price return volatility * Pre-Crisis Average is the average level from 7/1/06 through 6/30/07 Source: Morgan Stanley Research, Morgan Stanley Quantitative and Derivative Strategies, Bloomberg Portions of this report regarding non-US options are not intended for US clients, other than Institutional Clients. Investing in options is not suitable for all investors. Please see the disclosures at the end of this report and discuss whether this or any particular options strategy is suitable with your Morgan Stanley representative. Please direct all market-specific questions to the coverage analyst and all options-specific questions to Sivan Mahadevan, Derivative Research Strategist. Sivan Mahadevan (212) 761-1349, [email protected]

45

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Option Strategy Risk Factors Calls: The maximum potential loss is the premium paid. Call Spreads: The maximum potential loss is the premium paid. Overwriting (selling calls over long stock positions): At expiry the risk is that the stock rallies through the short call strike, with the stock called away at the strike price, limiting participation in further upside. Puts: Overlaid on a long stock position, the position is protected below the strike at expiration. The maximum potential loss in isolation is the premium paid. Put Spreads: Overlaid on a long stock position, the position is protected between the strikes (but not below) at expiration. The maximum potential loss in isolation is the premium paid.

Dividend Futures/Swaps: Investors long dividend futures/swaps participate 1:1 in movements on the underlying dividend levels. If the dividend index rises the position will show a profit and a loss if the index falls below the entry price. Variance/Volatility Swaps: At expiry, an investor long/short a variance/volatility swap will be paid the difference between the volatility (squared for variance) and the strike price (or vice-versa for short variance positions) that is realized over the term of the contract. If realized volatility is above the strike price, there will be a gain/loss, and if realized volatility is below the strike price, there will be a loss/gain. Prior to expiry, spot starting variance swaps have exposure to both implied and realized volatility, with the realized volatility exposure progressively accruing and the implied volatility exposure decaying.

Underwriting (selling puts): The max loss is the strike less the premium. Above the strike investors keep the yield, but must be willing to miss out on any near-term upside as well. Put Spread Collars: Overlaid on a long stock position, the position is protected between the strikes at expiration. If the stock rallies through the short call strike, investors could be forced to sell their stock and upside will capped. The maximum loss on the option position alone is unlimited due to the short call. Call Spread Collars (Call Spread + Short Put): Overlaid on a short stock position, the position is protected between the strikes (but not above) at expiration, while profit is capped below the strike of the put sold. The maximum potential loss in isolation is the level of the put strike plus/minus the initial premium. Straddles and Strangles: The maximum potential loss on a long straddle or strangle is the premium paid. The maximum potential loss on a short straddle or strangle is unlimited.

46

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

Options Disclosure Options are not for everyone. Before engaging in the purchasing or writing of options, investors should understand the nature and extent of their rights and obligations and be aware of the risks involved, including the risks pertaining to the business and financial condition of the issuer and the underlying stock. A secondary market may not exist for these securities. For customers of Morgan Stanley & Co. Incorporated who are purchasing or writing exchange-traded options, your attention is called to the publication “Characteristics and Risks of Standardized Options;” in particular, the statement entitled “Risks of Option Writers.” That publication, which you should have read and understood prior to investing in options, can be viewed on the Web at the following address: http://www.optionsclearing.com/about/publications/character-risks.jsp. Spreading may also entail substantial commissions, because it involves at least twice the number of contracts as a long or short position and because spreads are almost invariably closed out prior to expiration. Potential investors should be advised that the tax treatment applicable to spread transactions should be carefully reviewed prior to entering into any transaction. Also, it should be pointed out that while the investor who engages in spread transactions may be reducing risk, he is also reducing his profit potential. The risk/ reward ratio, hence, is an important consideration. The risk of exercise in a spread position is the same as that in a short position. Certain investors may be able to anticipate exercise and execute a "rollover" transaction. However, should exercise occur, it would clearly mark the end of the spread position and thereby change the risk/reward ratio. Due to early assignments of the short side of the spread, what appears to be a limited risk spread may have more risk than initially perceived. An investor with a spread position in index options that is assigned an exercise is at risk for any adverse movement in the current level between the time the settlement value is determined on the date when the exercise notice is filed with OCC and the time when such investor sells or exercises the long leg of the spread. Other multiple-option strategies involving cash settled options, including combinations and straddles, present similar risk. Important Information: • Examples within are indicative only, please call your local Morgan Stanley Sales representative for current levels. • By selling an option, the seller receives a premium from the option purchaser, and the purchase receives the right to exercise the option at the strike price. If the option purchaser elects to exercise the option, the option seller is obligated to deliver/purchase the underlying shares to/from the option buyer at the strike price. If the option seller does not own the underlying security while maintaining the short option position (naked), the option seller is exposed to unlimited market risk. • Spreading may entail substantial commissions, because it involves at least twice the number of contracts as a long or short position and because spreads are almost invariably closed out prior to expiration. Potential investors should carefully review tax treatment applicable to spread transactions prior to entering into any transactions. • Multi-legged strategies are only effective if all components of a suggested trade are implemented. • Investors in long option strategies are at risk of losing all of their option premiums. Investors in short option strategies are at risk of unlimited losses. • There are special risks associated with uncovered option writing which expose the investor to potentially significant loss. Therefore, this type of strategy may not be suitable for all customers approved for options transactions. The potential loss of uncovered call writing is unlimited. The writer of an uncovered call is in an extremely risky position, and may incur large losses if the value of the underlying instrument increases above the exercise price. • As with writing uncovered calls, the risk of writing uncovered put options is substantial. The writer of an uncovered put option bears a risk of loss if the value of the underlying instrument declines below the exercise price. Such loss could be substantial if there is a significant decline in the value of the underlying instrument. • Uncovered option writing is thus suitable only for the knowledgeable investor who understands the risks, has the financial capacity and willingness to incur potentially substantial losses, and has sufficient liquid assets to meet applicable margin requirements. In this regard, if the value of the underlying instrument moves against an uncovered writer’s options position, the investor’s broker may request significant additional margin payments. If an investor does not make such margin payments, the broker may liquidate stock or options positions in the investor’s account, with little or no prior notice in accordance with the investor’s margin agreement. • For combination writing, where the investor writes both a put and a call on the same underlying instrument, the potential risk is unlimited. • If a secondary market in options were to become unavailable, investors could not engage in closing transactions, and an option writer would remain obligated until expiration or assignment. • The writer of an American-style option is subject to being assigned an exercise at any time after he has written the option until the option expires. By contrast, the writer of a European-style option is subject to exercise assignment only during the exercise period.

47

MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

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MORGAN STANLEY RESEARCH

Global Debates Playbook June 22, 2012

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Overweight/Buy Equal-weight/Hold Not-Rated/Hold Underweight/Sell Total

Investment Banking Clients (IBC)

Count

% of Total

Count

% of Total IBC

% of Rating Category

1133 1250 99 461 2,943

38% 42% 3% 16%

471 472 27 121 1091

43% 43% 2% 11%

42% 38% 27% 26%

Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months. Analyst Stock Ratings Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.

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Disclosure Section (Cont.) Analyst Industry Views Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below. In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below. Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below. Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index. 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Additional information on recommended securities/instruments is available on request. 6-21-12 po/sm/wn

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