INVESTMENT MANAGEMENT JOURNAL Investment Management … · Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents

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Investment Management Journal

01 A Letter from Dan Simkowitz

03 Global Chess Game: A New Framework to Navigate Competitive Currency Devaluation and Policy Dominance

Marco Spaltro, Ph.D., Vice President Jim Caron, Managing Director

11 Why We Write Amay Hattangadi, Executive Director Swanand Kelkar, Executive Director

15 A Value Opportunity in U.S. Investment Grade Corporates Joseph Mehlman, CFA, Executive Director Mikhael Breiterman-Loader, CFA, Vice President

21 Fundamental Tax Reform: How Corporate Inversions May Drive the Issue to Enactment in 2017

David Kemps, Executive Director

29 Are Emerging Market Foreign Currencies Finally Attractive? Teal Emery, Senior Associate Jens Nystedt, Ph.D., Managing Director

41 Portfolio Strategy: The Diversification Myth and Volatility Failure

Martin Leibowitz, Managing Director Anthony Bova, CFA, Executive Director

51 About the Authors

INVESTMENT MANAGEMENT

2016 | VOLUME 6 | ISSUE 1

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1

A LETTER FROM DAN SIMKOWITZ

January 2016

With a new year upon us, we stand on the edge of a new economic cycle now that the Federal Reserve has finally raised interest rates. As a long-time Morgan Stanley veteran and having most recently served as co-head of Global Capital Markets, I am excited about the insights our firm’s investment professionals can provide to our clients. From my days spent working with our clients on some of the largest capital raisings in history, I know firsthand that investors are increasingly seeking managers to deliver solutions and I believe that we offer a compelling offering in this regard.

Inside this issue, you will find a framework to help navigate a world in which major central banks may have conflicting policy goals, a discussion about the value opportunity in U.S. investment grade corporate bonds, and an introduction to a model for evaluating emerging market currencies. We also consider the advantages of putting one’s thoughts down on paper, a discipline that may be helpful in the investing world, and take a close look at corporate inversions. Finally, we end with an examination of the drawdown effect on diversified portfolios in light of the financial crisis.

We hope that these pieces spur additional conversations and welcome the opportunity to continue this dialogue. On behalf of our firm, I wish you a wonderful 2016.

Sincerely,

Dan Simkowitz Head of Morgan Stanley Investment Management

DAN SIMKOWITZHead of Morgan Stanley Investment Management

2

INVESTMENT MANAGEMENT JOURNAL | VOLUME 6 | ISSUE 1

3

GLOBAL CHESS GAME: A NEW FRAMEWORK TO NAVIGATE COMPETITIVE CURRENCY DEVALUATION AND POLICY DOMINANCE

Introducing a new framework – the Global Chess GameThe goal of central banks from the hardest hit economies during the financial crisis has been to ease financial conditions, reflate asset prices and, ultimately, support inflation. Activism by major central banks created what we referred to as “policy dominance” and it became a core part of our investment thesis.1 But this thesis, which relied on the consistency of easy policy to reflate asset prices, will be put to the test as the Federal Reserve (Fed) may reverse course and raise interest rates. In contrast, the People’s Bank of China (PBoC) and the European Central Bank (ECB) have moved in the opposite direction and adopted an easier monetary policy stance.

A new framework is, therefore, required to navigate this new regime of policy dominance in which major global central bank policy goals are currently at odds with each other. We call it the Global Chess Game (GCG) in which asset prices are mainly driven by the interactions of global central banks competing with each other to reach domestic inflation targets while simultaneously trying to maintain financial market stability. At the nexus of these competing goals is where we believe alpha and investment opportunities exist.

From an investment perspective, the GCG suggests that we will likely realize modest global growth without the risk of rapidly rising interest rates in the near term. This is because central banks from economies that are poised to recover, such as the U.S. and UK, may have to increase policy rates more

Global Chess Game: A New Framework to Navigate Competitive Currency Devaluation and Policy Dominance

AUTHORS

1 Global Fixed Income Insights, “Reflationary Central Bank Policies Make Positive Real Yields Attractive”, Jim Caron, September 2012.

MARCO SPALTRO, PH. DVice President

JIM CARONManaging Director

4


slowly to avoid a “lowflation trap”.2 Meanwhile, economies that are weakening may be able to ease policy rates more aggressively, coupled with a reduced risk of an inflationary outcome. Inflation and inflation expectations may remain low in the medium term as a result.

Broadly, this should be supportive of credit and carry-related investments as default risk may remain low given that central bank policy support will likely continue to be a dominant feature of the investment cycle. Additionally, this suggests a structural reduction in term premium that may be supportive of flat global yield curves. Of course, idiosyncratic risks will remain as the policy cycle is unsynchronized, which we believe is to the advantage of actively managed fixed income strategies.

Starting the Chess Game – The Opening RepertoireTo illustrate our point, we make the analogy of a chess game to global central bank polices. At the beginning of the game, the global economy is at an arbitrary point of equilibrium, similar to a chess board, with the pieces representing policy tools that are used to achieve one’s goal—growth and inflation—the king. Once a central bank makes an initial move to achieve a new equilibrium, it sets in motion a sequence of moves from other central banks, which we refer to as the opening repertoire. Suddenly, the game becomes unbalanced and requires more policy changes until a new equilibrium is achieved.

Following the “crossing of the Rubicon” and the onset of the ECB’s Quantitative Easing (QE) program, President Mario Draghi was seen on a flight (in economy class) from Frankfurt to Rome playing chess on his iPad.3 With global deflationary pressures, persistent slack in major economies and with ECB aggressively devaluing the euro, the GCG has started and other global central banks have reacted. In this game, central banks compete against each other by easing monetary policies in an attempt to meet their domestic, inflation-targeting mandates. Lack of coordination among central banks may mean that

monetary policy remains lower for longer, leading to a semi-permanent low-yielding environment. At the end of the GCG, we are likely left with more central bank money, higher asset prices, low inflation and low yields (Display 1).4 It is difficult for central banks not to play or to leave the Game—for such a decision, the price to pay is potential deflation.

Unconventional monetary policy is supposed to support the real economy and, ultimately, increase inflationary pressures. But what we observed after several years of ultra-low interest rates is something different. While economic growth has returned (albeit lower than pre-crisis levels), inflation has failed to appear. We would argue that part of the reason for lowflation is the same unconventional policies that are supposed to generate inflation—a low interest rate environment leading to a misallocation of resources that stifles economic growth.

The GCG is a useful framework for understanding financial market movements in a world dominated by monetary policy. The implications of the GCG are clear: duration will likely trade in a range. When yields and currencies rise with improving fundamentals, they tend to lead to lower inflation and central bank interventions, thus binding yields in a tight range. In the currency markets, central banks less willing to play the GCG may see their currencies appreciate and bear the brunt of global deflation.

2 Lowflation means an ultralow inflationary environment where inflation remains persistently below the inflation target.3 http://www.bloomberg.com/news/articles/2015-01-26/draghi-plays-chess-in-economy-after-journey-to-trillion-euro-qe

4 In this paper we do not attempt to explain an initial lowflation, low growth environment. Rather, it is a given in this framework. The Secular Stagnation hypothesis (Summers, 2014), Savings Glut hypothesis (Bernanke, 2011) or demographic trends are all plausible explanations (Haldane, 2015). We argue, however, that the GCG exacerbates secular macroeconomic dynamics already in place, which will likely maintain low yields.

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Display 1: The forecasted workings of the Global Chess Game with two central banks

WeakerFX 1

StrongerFX 2

Lowflationfor country 2

QE byCB 2

WeakerFX 2

StrongerFX 1

Lowflationfor country 1

QE byCB 1

InitialLowflation

Higher CB liquidityHigher asset prices

Low inflationLow yields

Note: This chart is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. There is no assurance that this forecasted scenario will be achieved. This flow chart refers to a cycle that is catalysed by an initial lowflation impulse. It triggers an arbitrary first central bank (CB1) to engage in policy easing, which, in turn weakens its currency (FX1) relative to another currency (FX2). This creates low inflation in country 2 that prompts an easing policy response to weaken FX2. The chained reaction amongst the central banks are what we refer to as the Global Chess Game.

Source: Morgan Stanley Investment Management.

Origins of the Global Chess GameSince January 2015, many global central banks have cut interest rates or embarked on QE programs to counteract relative appreciation of their currencies and combat deflationary pressures.

In this environment, interaction among central banks rather than domestic fundamentals becomes the key driver of assets’ returns in our opinion. This leads us to a question: what is the optimal response of a central bank given actions of other major central banks? We argue that the GCG is a useful framework for understanding fixed income markets in which central banks follow their domestic inflation targets and operate at the zero interest rate lower bound. We also argue that this game is leading to excessively low policy rates, which, in turn, will make them stickier. But how did we get to the GCG? And what are the potential implications for financial markets?

Can unconventional policies induce lowflation?Unconventional monetary policy is supposed to support the real economy and, ultimately, increase inflationary pressures. For example, QE should increase asset prices via the portfolio rebalancing effect5 and support credit creation through the bank lending channel. The impact would, in turn, increase consumption, investments and, thus, inflation (see Display 2). While the bank lending channel is likely to have limited effects on bank lending (see Joyce and Spaltro, 2014; and Butt et al., 2014) and therefore inflation, asset prices have strongly increased following QE and other unconventional policies. For example, U.S. equities prices, based on the S&P 500 Index, rose over 180 percent, catalyzed by the start of QE in the U.S. in November 2008.6

Display 2: Classic transmission mechanism of QE

Expectations

↑ Asset prices(↓ yields)

↑ Money in the economy

Bank ofEnglandassetpurchases

↑ Total wealth

↓ Cost ofborrowing

↑ Bank lending

↑ Spendingand income Inflation at 2%

Source: Benford et al. (2009)

But what we observed after several years of ultra-low interest rates is something different. While economic growth has returned (albeit lower than pre-crisis levels), inflation has failed to appear. Our composite inflation “pulse” suggests that inflationary pressures are not on the horizon for major

5 The portfolio rebalancing effect is the key transmission mechanism of QE to asset prices. When a central bank buys government bonds, it reduces risk-free bonds, expected returns. Investors will then tend to move away from this asset class into riskier assets, e.g., corporate bonds and equities, thus lowering risk premia and supporting the real economy. This process of asset rotation is called the portfolio rebalancing effect. See Benford et al. (2009) for a fuller description.6 Source: S&P. Data as of August 19, 2015.

6


developed market economies (Display 3).7 We would argue that part of the reason for lowflation is the same unconventional policies that are supposed to generate inflation.

First, ultra-low interest rates tend to reduce the incentives to deleverage helping maintain the level of debt above its long term trends, diverting investments from more productive uses and, hence, stifling economic growth. This factor may even have contributed to very low rates of productivity growth in developed economies (see BIS, 2015). Low rates may also have labor force compositional effects—all things being equal, it helps low-skilled labor force formation—weighing down on productivity and wages (see BoE, 2015). In other words, major central banks may have traded short-term output gains (recession was milder) for long-term economic loss. In the world of central banking, there is no such thing as a free lunch.

Display 3: Inflation pulse is weak for major developed market economies

Switzerland

Canada

US

Sweden

Norway

NZ

Japan

UK

EA

Australia

’04 ’15’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’14’13 Prior Latest

-1.4

-0.5

-1.1

-0.4

0.0

-1.2

0.1

-1.3

-1.3

-1.2

-1.4

-0.9

-1.0

-0.4

0.0

-1.2

0.2

-1.3

-1.1

-1.2

Note: Dark gray - Bright green scale varies for z-score range of [-1.65, 1.65]

Source: Bloomberg LP, Haver Analytics, Morgan Stanley Investment Management calculations. Data as of July 23, 2015. ‘Latest’ refers to the most recent monthly inflation data. ‘Prior’ refers to the second most recent monthly inflation data.

Second, the inflationary process of QE may have stopped at assets’ inflation and did not generate purchases of newly produced goods or services. As consumers and companies remain scarred after the financial crisis (see Haldane, 2015), increases in wealth may not coincide with increases in consumption or investments.

Third, low interest rates reduced banks’ net interest margins as the potential returns on the assets continued to drift lower, while it is challenging for banks to charge their customers for deposits. All things being equal, this reduced capital buffers, thus leading to a decline in lending supply. And initial empirical estimates tend to confirm that QE did not have a strong effect on the supply of loans (Butt et al., 2014 and Joyce and Spaltro, 2014) so that the effect on inflation via this channel should be muted.

If the effect of QE on inflation is limited, the depreciation of the currency remains an important (if not the most effective) tool to affect inflation and inflation expectations.

What does the limited ability to support inflation mean for monetary policy?If central banks’ unconventional monetary policy can do little to support inflation via the main transmission channels (e.g., asset prices and bank lending channel), the most likely adjustment will have to happen via the foreign exchange rate. That is why we saw an increase in attention by central banks to exchange rates. The Riksbank has been one of the most active central banks lately, focusing on currency movements where an appreciation of the Swedish currency triggered deposit rate cuts, which are now deeply in negative territory (Riksbank, 2015). The Riksbank became one of the best players of the GCG. With lowflation, central banks seek to protect their domestic interests by devaluing their currencies and shifting deflationary pressures across the globe (Display 4).

Lack of coordination between central banks may lead to loose global monetary policy for global economic fundamentals, which in turn may exacerbate misallocation of resources and detract from long-term growth. This suggests that the GCG may have compounded the lowflationary effects of QE.

It is difficult, however, to argue that central banks should raise rates to induce inflation, as it will probably have the opposite effect. In the GCG world, an interest rate adjustment may be overdue but will also be a costly process as the currency will take the brunt of the adjustment, lowering further inflation and inflation expectations.

7 We use Principal Component Analysis to track several inflation indicators bucketed in goods inflation, producer prices inflation, wages inflation and inflation expectations.

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At the same time, maintaining low interest rates for extended periods has costs in terms of lower economic growth. Thus, raising policy rates slightly may even be beneficial from a cost-benefit analysis perspective.

And the benefits of such action could be even higher with more coordination across major central banks. They would jointly decide who needs easing the most, with the stronger countries able to absorb the resulting deflationary pressures. An alternative would be for central banks to focus on longer-term financial trends rather than short-term inflation and growth targets (BIS, 2015.)

What does it mean for fixed income and currency markets?First, the GCG fixed income market will become more tactical. Fundamentals are important but lowflation and interaction among global central banks are key drivers of returns in our opinion. In order to generate return in a world of low risk premia (Display 5), timing reversals correctly will become a larger part of expected returns.

Second, if economic growth is structurally lower and central banks compete via adjustments in foreign exchange (a scenario in which we believe we are currently in via the GCG), yields may remain lower than ordinary and potentially range bound. Signs of a strengthening economy (for example higher yields and a stronger currency) will be met by central bank intervention that will keep longer maturity bond yields from rising quickly.

Third, best opportunities (in terms of expected returns) are where central banks still have scope to lower policy rates and are in the process of adjusting toward the lowest central bank rate as inflation rates converge. These so called global satellites (e.g., Canada, New Zealand and Australia)8 provide some attractive investment opportunities in our opinion.

Currency markets will likely continue to be dominated by their relative monetary policy stances. We suggest investors consider longing the currencies for central banks less willing to play the GCG (i.e., U.S. dollar, British pound) and shorting central banks keen to play (i.e., New Zealand

dollar, Australian dollar and Canadian dollar). However, as with duration, currency positioning should remain tactical. As inflation converges quickly via adjustments in foreign exchange, central banks will likely change their stances to meet their domestic mandates.

Display 4: Low inflation in Europe is shifting to other global economies

-1

0

5

2

1

3

4

2006 2015

Average CPI (USD, GBP, JPY, CAD, AUD, NZD, NOK) Average CPI (EUR, SEK, CHF)

2007 2008 2009 2010 2011 2012 2013 2014

Source: Thomson Reuters Datastream. Data as of June 24, 2015.

Display 5: Term premia for major sovereign bond curves

-2

1

3

0

1

2

1996 2014

US Germany

1998 2000 2002 2004 2006 2008 2010 2012

Term

Pre

miu

m %

Japan UK

Source: Morgan Stanley Investment Management, Haver Analytics, Blue Chip Forecasts. Data as of August 7, 2015.

8 Global Satellites are small and open economies whose policy is linked indirectly to major central banks’ policy.

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ReferencesBIS (2015), Is the Unthinkable Becoming Routine?, 85th Annual Report, 2014/2015.

Bank of England (2015), Inflation Report, August.

Benford, J., et al. (2009), Quantitative Easing, BoE Quarterly Bulletin, Q2.

Bernanke, B., S., (2011), Global Imbalances: Links to Economic and Financial Stability, Speech at the Banque de France.

Butt, N., Churm, R., McMahon, M., Morotz, A., and Schanz, J. (2014), QE and the bank lending channel in the United Kingdom, BoE WP No. 511.

Haldane, A.G. (2015), Stuck, Open University, London, 30 June.

Joyce, A.G. and Spaltro, M. (2014), Quantitative Easing and Bank Lending: A Panel Data Approach, BoE WP no. 504.

Riksbank policy statement (2015), March.

Summers, L. (2014). “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound”, Business Economics, Vol. 49, No. 2, National Association for Business Economics.

ConclusionWe believe that the Global Chess Game is a useful framework to inform our investment decisions where monetary policy becomes increasingly unsynchronized. The GCG has clear investment implications: 1) global inflation and growth are likely to remain subdued; 2) yields may remain range-bound; and 3) global satellites, such as Canada, New Zealand and Australia, provide good opportunities as central banks still have scope to ease monetary policy.

Developments in the interaction among major central banks remain highly uncertain. While the GCG started on an economy flight from Frankfurt, it is still unclear from which city the return flight will depart.

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IMPORTANT DISCLOSURESThe views and opinions are those of the authors as of August 2015 and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all portfolio managers at MSIM or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

All information provided is for informational purposes only and should not be deemed as a recommendation. The information herein does not contend to address the financial objectives, situation or specific needs of any individual investor. In addition, this material is not an offer, or a solicitation of an offer, to buy or sell any security or instrument or to participate in any trading strategy. All investments involve risks, including the possible loss of principal.

RISK CONSIDERATIONSThere is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in a portfolio. Please be aware that portfolios may be subject to certain additional risks.

Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall. In a declining interest-rate environment, the portfolio may generate less income.

Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments.

Past performance is no guarantee of future results.

Charts and graphs provided herein are for illustrative purposes only.

The material contained in this article is current as of the publication date of the article, is intended for informational purposes only and does not purport to address the financial objectives, situation or specific needs of any individual investor. It has been obtained from sources believed to reliable, but Morgan Stanley cannot guarantee its accuracy or completeness. The use of this article is not a solicitation, or an offer to buy or sell any security or investment product. In addition, this material is not an offer, or a solicitation of an offer, to buy or sell securities in the regions and sectors mentioned.

This communication is a marketing communication. It is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. All information contained herein is proprietary and is protected under copyright law.

Morgan Stanley is a full-service securities firm engaged in a wide range of financial services including, for example, securities trading and brokerage activities, investment banking, research and analysis, financing and financial advisory services.


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11

WHY WE WRITE

There is a Chinese saying that the faintest ink is more powerful than the strongest memory. This is a simple truth about writing things down so that one does not have to rely on memory alone for recollection. Yet, this is lost on many, especially in the investing world. We were fortunate that early on in our careers we worked under bosses who made us write down stock investment theses, ideally not extending beyond a few bullet points. To borrow a line from Warren Buffett, “this is simple but not easy.” We have spent many a morning at our desks trying to write an honest rationale for a stock that we have fallen in love with, only to toss out sheet after sheet into the waste paper basket.

From our perspective, a stock rationale should have three parts. First, there should be a description of the key business advantages. Some people call this the moat around a business, and the description should also include a view on sustainability of these advantages. Deep distribution reach, low cost of production, sustained pricing power or intellectual property rights on a product or service are some examples. One should also look for metrics that reinforce this description of moat, like market share, change in market share, superior profitability or return ratios.

Second, there has to be a description of the business drivers for next 12 to 18 months. If the moat is about structural advantages, this part is more about cyclical changes that one is expecting. Again, this has to be quantified with measurable metrics like expected sales growth, operating margin, earnings, return on equity etc.

Third, it should be clearly defined where one differs from consensus market expectations. If the rationale reads like a consensus report then it is quite likely that all the good things are in the price. In our opinion, an ideal

Why We WriteAUTHORS

AMAY HATTANGADIExecutive Director

SWANAND KELKARExecutive Director

12


investment opportunity comes along when a solid moat is clouded by short-term challenges and the market decides to focus more on the challenges than the structural advantages.

Rationales should end with a “review” price, as opposed to “target” price, which is one’s estimate of what the fundamental value of the stock should be, based on current information. The emphasis here is on review price rather than target price because the latter merely denotes an exit price for the stock, whereas often the process of evaluating an existing investment involves periodic review, as and how goal posts are achieved.

The biggest advantage of writing things down is that it forces one to rummage through data to back one’s argument. For good measure, send your rationale to a large number of people. Putting it out there for all to see makes one more accountable and hence careful. Writing things down also helps weed out half-baked ideas at the initial stage, before they can damage the portfolio. Often, one comes out of corporate meetings where a chief executive officer with great presentation skills has held sway and enthralled you. The halo effect creates an urge to press the buy button then and there, but writing down the investment thesis acts as a circuit breaker. What felt like a no-brainer a few moments ago, does not feel that way once the rubber hits the road or in this case, the pen hits the paper.

Having clear operational metrics with every rationale helps measure actuals against expectations. Thus, every quarter when the relevant data points come out, it is essential that the original rationale is revisited to see if the thesis is on track or needs re-assessment. To be sure, one does not have to be robotic about this; that is, just because a metric is not reached, a stock has to be automatically sold but the process of re-assessment is critical. In investing, stock theses will

inevitably go wrong, and such timely assessments help in limiting the likely damage from slow poison and steering clear of value traps. In the happy instances where the review price has been reached, it is important to see whether this has been reached primarily through re-rating or because operational metrics surprised on the upside. If it has been mainly through operational outperformance, setting a fresh review price is easier.

Filtering out the signal from the noise is possibly the most difficult skill that an investor has to master. In times of volatility when emotions and headlines tend to hold sway over one’s thinking, re-visiting the rationale to see how much of it affects the original thesis has a calming effect. It is surprising how little impact daily breaking news has on such rationales. Also, during times of volatility, some potentially great bargains may become available. If one has a review price handy for such stocks (this time lower than market price), buying things when there is blood on the street becomes easier.

Unlike sportspeople, investors do not have sophisticated frame-by-frame action replays to correct flaws and improve technique. Having a collection of rationales written over time is the best that we have and a record of one’s own thought process helps unearth biases and mistake patterns. Being cognizant and rectifying them will go a long way in accelerating one’s evolution as an investor. Also, when the chips are down, it is a morale booster to read an old rationale that played out well and gave large returns.

The most frequent sentiment that we get from investors is that “We are numbers people, not writers!” but all it takes is lucid articulation of thoughts in simple language. And as regular readers of this newsletter will agree, one does not have to be a Hemingway1 to write about investing.

1 Ernest Miller Hemingway was an American author and journalist.

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WHY WE WRITE

IMPORTANT DISCLOSURESThe views and opinions are those of the author as of the date of publication and are subject to change at any time and may not necessarily come to pass. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM)or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.



Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments.

Forecasts and estimates are subject to change and may not necessarily come to pass due to changing market and/or economic conditions.

Past performance is no guarantee of future results.

The information, charts and graphs in this report are for infor-mational purposes only, and should in no way be considered a research report from MSIM, as MSIM does not create or produce research. Morgan Stanley is a full-service securities firm engaged in a wide range of financial services including, for example, securities trading and brokerage activities, investment banking, research and analysis, financing and financial advisory services.

EMEA:For Business and Professional Investors and May Not Be Used with the General Public.

This communication was issued and approved in the UK by Morgan Stanley Investment Management Limited, 25 Cabot Square, Canary Wharf, London E14 4QA, authorized and regulated by the Financial Conduct Authority, for distribution to Professional Clients or Eligible Counterparties only and must not be relied upon or acted upon by Retail Clients (each as defined in the UK Financial Conduct Authority’s rules).

US:This communication is a marketing communication. It is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. All information contained herein is proprietary and is protected under copyright law.



Australia:This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act

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15

A VALUE OPPORTUNITY IN U.S. INVESTMENT GRADE CORPORATES

Recent Developments / Executive SummaryDuring August, the Barclays U.S. Investment Grade Corporate Bond Index widened to a level not witnessed since the third quarter of 2012. After spreads relative to U.S. Treasuries reached a post-crisis low of 99 basis points (bps) in July 2014, U.S. Investment Grade (IG) spreads have steadily widened over the past year (See Display 1). We believe the majority of this widening has been driven by macro factors and is not an accurate reflection of fundamental credit risks within the corporate sector.

Display 1: Recent widening of IG corporate spreads creates value opportunityIndex spreads relative to U.S. Treasuries (basis points)Monthly Data as at July 2015

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Source: Barclays Capital and Morgan Stanley Investment Management.Past performance is no guarantee of future results.

A Value Opportunity in U.S. Investment Grade Corporates

AUTHORS

JOSEPH MEHLMAN, CFAExecutive Director

MIKHAEL BREITERMAN-LOADER, CFAVice President

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Since the middle of 2014, the U.S. IG market has faced numerous and persistent headwinds, starting with falling energy prices and extending to questions surrounding U.S. Federal Reserve (Fed) policy, concerns about a Greek exit from the eurozone, a slowing Chinese economy and falling commodity prices. We believe the risks that China poses to the U.S. economy and corporate markets are manageable. We see U.S. economic growth supporting an eventual rate rise (whether in September, December or later) which will signal the beginning of a very slow tightening cycle in the U.S. This should be supportive of U.S. IG corporates.

Our analysis has shown that corporate spreads have performed well in environments where interest rates rise in a controlled manner. There is a risk that the market may overreact to the Fed’s eventual announcement, but we expect the Fed will be very careful in both their actions and communications to avoid a Taper Tantrum-type reaction. We expect a continuation of tepid but sustained global growth (with the U.S. leading the pack), low inflation and continued demand for yield from global investors.

Given our constructive views, we have recently increased IG exposure in portfolios, although we acknowledge that timing the inflection point will be challenging. We believe that a strategy focused on high-quality financials as well as non-financial domestically U.S. oriented corporates, with little direct commodity exposure, is the right approach to add value to portfolios over time. There will also be opportunities in commodity-sensitive Credits in the Energy and Metals sectors but with more volatility expected there, we are being more patient in these particular sectors.

Macro FundamentalsRecent macro discussions have focused on the slowing Chinese economy and the risk China poses to the broader global economy. While topical, we do not believe China has a direct material impact on the U.S. economy and, by extension, most U.S. IG Corporates. Work done by our MSIM colleagues suggests that a 1 percent slowdown in China may only lower U.S. GDP by 0.1 to 0.15 percent. If we assume China is slowing by approximately 2.5 percent, that would suggest a 0.30 percent decline in U.S. growth. This should enable U.S. growth to remain comfortably above recent trend in the 2 to 2.5 percent range, supportive of the Corporate sector.

Historically, this level of U.S. growth has created a very favourable backdrop for corporates. Growth is sufficiently high in our opinion to ward off defaults while not being so fast that it encourages companies to act in ways that are overly friendly to shareholders and to the detriment of bondholders (e.g., aggressive M&A or debt-financed share buybacks). While we have witnessed a resurgence of M&A activity in the IG space, the vast majority of these deals have been financed with a mix of debt and equity, providing a degree of spread and ratings stability uncommon in the prior cycle (See Display 2).

Display 2: M&A volume and deal countQuarterly Data as at June 2015

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Source: Bloomberg and Morgan Stanley Investment Management.

Much attention has also been given to the eventual change in U.S. monetary policy, and markets have reason to be wary after the Taper Tantrum in 2013. However, we believe that the Fed learned an important lesson from that episode and will give extra attention to its communication strategy this time. We expect that when the Fed decides to act (whether that be in September, December or even early 2016), they will move rates on a very slow and gradual path. U.S. IG corporates should respond favourably to these conditions. Analysis we have performed confirmed that U.S. IG spreads tend to perform well in periods of gradually rising rates. Not only will higher rates signal continued strength and stability in the U.S. economy, they will also help to bring yield-sensitive buyers back into the market.

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Credit FundamentalsFundamentals within the IG corporate markets vary by sector but remain largely favorable despite some recent moderate deterioration. With the Non-Financial sector later in the business cycle, we have witnessed a steady and modest deterioration in company fundamentals over the past couple of years. This has allowed gross and net leverage to rise to levels not seen since the early 2000s.1 While this trend is certainly not supportive of bondholders, we do find some comfort in that the bulk of this deterioration has been the result of active decisions by management teams rather than EBTIDA declines (leaving aside the Energy and Metals sectors where top line growth is pressured).2 Thanks in part to ample cheap capital, companies have been willing to increase leverage to fund stock buybacks or mergers. As these are discretionary activities, we have already seen examples of companies halting buyback programmes when leverage targets were breached. We are also not seeing aggressive financial engineering (such as LBOs) as we did in the mid-2000s. Additionally, despite a steady rise in leverage, interest coverage for most companies is holding near all-time highs, which means companies are well positioned to service their debts.3

While the non-financial corporate sector has been gradually relevering, the Financial sector (banks in particular) remains in an earlier, and less expansionary, phase of the business cycle. Most large U.S. banks have spent the past few years de-risking and de-levering their balance sheets, behavior which is well aligned with the interests of bond holders. These institutions also remain under strict oversight by Federal regulators. Even for those institutions that have largely completed their balance sheet repair, such as some of the largest U.S. banks, regulators have tightly controlled plans to return cash to shareholders.

Supported by these positive fundamentals, we remain overweight Financials across portfolios. In the Non-Financial space, the expansionary behaviors make us more cautious though we have been opportunistic in adding attractively priced names during recent periods of volatility.

TechnicalsTechnicals in the IG market paint a very mixed picture. Demand for IG bonds remains very strong, as evidenced by strong new issue order books, oversubscribed deals, and narrower spreads when new bonds are sold to investors in comparison to the initial price talk. Additionally, stubbornly low yields in the government sector, especially in Europe, have driven more investors into the U.S. corporate market, in search of higher yields and carry.

Unfortunately, low yields and robust demand have also helped permit record new issuance in the IG sector. Total supply has grown each year since 2010, with 2015 on pace to break 2014’s record for all-time issuance (See Display 3).4 Much of the increase in supply has been driven by the M&A activity, particularly in the Non-Financial sector. Estimates vary, but we believe that M&A related financing explains much of the increase in issuance over the past couple of years.5 Even though spreads have been leaking wider, companies have been eager to issue bonds into the IG market to take advantage of low all-in yields.

Display 3: Annual gross IG new issuance (including estimated 2015 total)

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1 Source: Data and calculations from Morgan Stanley Research.2 Source: EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization.3 Source: Data and calculations from Morgan Stanley Research.

4 Source: Data and calculations from Morgan Stanley Research.5 Source: Data and calculations from Morgan Stanley Research.

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Another feature of this market has been the frequency of jumbo deals (one company issuing more than $10 billion of bonds at once). Between 2012 and 2014, our market saw just eight of these deals. In 2015, we have already seen 11 jumbo deals come to market, with even more possible for later in the year. With very few exceptions, these transactions have all been used to fund mergers or acquisitions. These large transactions, coupled with record overall amounts of supply, have at times caused some indigestion for the market. Spreads have tended to widen during periods of especially heavy supply. We believe this situation has been exacerbated by poorer liquidity conditions in the market, in particular smaller dealer inventories and balance sheets.

It is indisputable that liquidity has declined over the past few years. Much of this shift seems to have been driven by the financial regulatory climate, specifically Dodd-Frank (Volker) and Basel III, which have directly or indirectly increased the costs for broker-dealers to hold inventory. Inventories are now assigned larger capital charges (higher for lower quality assets) which has reduced dealer inventory, and subsequently reduced secondary market liquidity. There are also fewer large counterparties in the Credit market following consolidation or dissolution of several large U.S. firms, as well as the downsizing of U.S. operations by select European banks.

This evolving landscape has made us increasingly mindful of liquidity risk when managing our portfolios, even if it has not substantially altered our core investment process or philosophy. For example, additional attention must be paid to the liquidity risks of specific issuers or issues to ensure we are properly compensated to hold a name or security in light of evolving market conditions. We have also become more active in the new issue market and work to ensure that a meaningful portion of portfolios are invested in more current and liquid issues.

ValuationAt the end of August, the Barclays U.S. Investment Grade Corporate Index traded at 163bps over U.S. Treasuries. Looking at monthly data, that is the widest closing level since August 2012, and the broad corporate index is now 64 bps above the post-crisis lows reached last summer. Single A Financials and Industrials are 43 bps and 48 bps wider respectively, while BBB Industrials are 95 bps wider, explained in part by the larger weights in the Energy and Metals sectors.6 While the weakness in oil and metals prices can justify some of the moves in these commodity-sensitive sectors, we believe spreads for Financials and less commodity-sensitive Non-Financials now look very attractive relative to fundamentals. In light of a supportive regulatory environment and limited event risk, we continue to believe high quality Financials look very attractive. Non-Financial corporates also offer value, though careful credit selection is paramount as this segment of the market is firmly in an expansionary phase of the business cycle.

ConclusionIn conclusion, given the macro backdrop of sustained U.S. economic growth and low default risks, we see a significant value opportunity for investors in the U.S. corporate market. While macro developments may continue to create volatility in the short term, current levels of IG corporate spreads present attractive value for long-term investors. After trading inside of long term medians for much of 2014, spreads on the U.S. IG corporate Index have reached levels which we believe compensates investors well for the risks we have discussed. We expect spreads to be further supported by an improving U.S. economy and gradually rising interest rates. As we seek to add additional IG corporate exposure to portfolios, we remain cognisant that the business cycle has matured. As a result, we will remain reliant upon our active, value-oriented approach and bottom-up credit research process to help identify the best value opportunities, while avoiding those companies where we believe there is limited scope to earn attractive returns.

6 Source: Data from Barclays.

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IMPORTANT INFORMATIONThe views and opinions are those of the authors as of 25th September 2015 and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all portfolio managers at MSIM or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.



Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.


RISK WARNINGSPast performance is not a guarantee of future performance. There can be no assurance that the portfolio will achieve its investment objectives. Portfolios are subject to market risk, which is the possibility that the value of the investments and the income from them can go down as well as up and an investor may not get back the amount invested. Accordingly, you can lose money investing in this strategy. Please be aware that this strategy may be subject to certain additional risks. Investments in Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall. In a declining interest-rate environment, the portfolio may generate less income. Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with investments in foreign developed countries.

High yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and liquidity risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Municipal securities are subject to early redemption risk and sensitive to tax, legislative and political changes. Sovereign debt securities are subject to default risk Collateralized mortgage obligations (CMOs) can have unpredictable cash flows that can increase the risk of loss. Public bank loans are subject to liquidity risk

and the credit risks of lower rated securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). In addition to the risks associated with common stocks, investments in convertible securities are subject to the risks associated with fixed-income securities, namely credit, price and interest-rate risks.


There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index.

The Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable, corporate bond market.





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21

FUNDAMENTAL TAX REFORM: HOW CORPORATE INVERSIONS MAY DRIVE THE ISSUE TO ENACTMENT IN 2017

IntroductionFormer Senator Max Baucus (D-MT), now the U.S. Ambassador to China, once said “tax reform is a once-in-a-generation opportunity.”1 That may well be true, and policymakers have certainly spent the past several Congresses laying a strong foundation from which to bring that statement to fruition. But the idea of engaging in tax reform, simply for the sake of meeting a generational truism, may not necessarily be a sufficient incentive to turn a policy pronouncement into legislative reality in today’s partisan environment. This reluctance is especially true when the issue involves taxes, and where reform will potentially affect Americans of all income levels, and businesses of all sizes and forms. Couple that general reluctance with the inevitability, in fundamental tax reform, of having policymakers make choices as to winners and losers, and it becomes necessary for the issue to be driven forward out of necessity, rather than simply from a desire to engage in the exercise because it may happen to be good policy, and may happen to resonate with certain constituencies. Should tax reform occur in the coming years, it is likely because of external stimuli that propel the issue forward despite the natural tendency of policymakers to avoid difficult policy choices.

In this regard, there is a new resolve among members of Congress to engage in tax reform, centered on the issue of corporate inversions. The issue of corporate inversion transactions is not new, nor is it one that necessarily resonates with the American people. Yet, it could be the issue that drives Congress to enact broad fundamental tax reform legislation when the 115th Congress convenes in 2017. Of course, 2017 will bring us a new administration and a new Congress,

Fundamental Tax Reform: How Corporate Inversions May Drive the Issue to Enactment in 2017

AUTHOR

DAVID KEMPSExecutive Director Morgan Stanley Government Relations

1 United States Committee on Finance, Baucus Announces Goals for New Tax Code for New ERA, June 11, 2012.

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and the power structure in Washington will ultimately influence the prospects for enactment of major tax reform legislation. Yet, the urgency that members of Congress express when dealing with corporate inversion transactions leads us to believe that the time may finally have arrived, regardless of the outcome of the 2016 presidential and congressional campaigns, when Congress moves beyond rhetoric to complete this “once-in-a-generation” tax reform undertaking.

The Groundwork for Tax ReformDeveloping the foundation for engaging in fundamental tax reform is a time-consuming effort requiring multiple inputs over the course of several Congresses, allowing for a variety of viewpoints to be expressed more generally on myriad issues inherent in any substantive review of tax policy, and in particular with regard to provisions of the Code that would affect different constituencies. In this regard, the two tax-writing committees of Congress, the Finance Committee in the Senate, and Ways and Means Committee in the House, have engaged in an exhaustive look at the Code today, with an eye towards developing a record upon which to engage in a legislative effort that ultimately will lead to enactment of fundamental tax reform as pertains to both business constituencies (including international reform) and individuals. In many ways, the education effort has been a cooperative process between the two Congressional tax-writing committees, and most recently a bipartisan effort within each committee in reviewing various issues that will invariably arise when engaging in such a comprehensive and potentially profound undertaking.2 While partisanship will invariably and inevitably play a major role in any legislative effort that subsequently flows from the foundational groundwork that has and will continue to develop over the course of this 114th Congress, the recent effort at bi-partisanship, at least in developing a legislative record, may lead to a comfort level among members that allows for proper and meaningful discourse, one that could ultimately lead to a positive outcome for tax reform.

The Most Recent Effort – the Ill-fated Tax Reform Act of 2014While tax reform ultimately stalled in the last Congress for a variety of reasons, nonetheless the education effort that the Ways and Means Committee and Finance Committees undertook did lead to introduction of the first major tax reform legislation in decades. In February 2014, Ways and Means Committee Chairman Dave Camp (R-MI) released a discussion draft of a fundamental tax reform proposal, followed late in the 113th Congress by the introduction of H.R. 1, the Tax Reform Act of 2014.3 As 2014 was an important midterm election year, the prospects for Chairman Camp’s substantive tax reform proposal moving forward were minimal at best. Yet, releasing the legislative draft was an important first step in gauging public response to the chairman’s vision for fundamental tax reform, an effort that sought to simplify the complexities within the current Code, reduce marginal and corporate rates, eliminate the AMT entirely for businesses and individuals, and move us to a territorial tax system for companies operating in multiple countries, while offsetting the revenue loss associated with such changes by reducing or eliminating certain deductions and exemptions, to avoid increasing the deficit.4

Reaction to the Camp draft was swift, and mixed at best, but the exercise was extremely beneficial in that it helped to pinpoint the inherent problems Congress will have in moving forward with a major change in tax policy based even upon the laudable goal of simplification.5 If the exercise of the tax-writing committees during the 112th and 113th Congresses has taught us anything, it is that a compelling reason beyond simplification may be necessary to drive tax reform forward.

2 During the 113th Congress, the Ways and Means Committee formed 11 bipartisan working groups, co-chaired by majority and minority members, to focus on a particular issue(s) associated with fundamental tax reform. This current Congress, the Senate Finance Committee followed a similar path in creating five bipartisan working groups.

3 On December 10, 2014, H.R. 1, the Tax Reform Act of 2014, was introduced by Chairman Camp.4 The Alternative Minimum Tax (AMT) operates to ensure that individuals and corporations that are able to benefit from certain deductions, credits, or exclusions that allow them to reduce their regular income tax liability, pay at least a minimum amount of tax.5 For example, when asked his thoughts regarding the Camp draft, then Speaker John Boehner simply replied, “blah, blah, blah, blah.” The Washington Post, Boehner on Tax Reform: Blah, Blah, Blah, Blah, February 26, 2014.

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The Corporate Income Tax in the United StatesWhen policymakers focus on corporate taxation, the issues invariably reduce to two main areas; the rate at which corporations (C corporations) are taxed, and the manner in which the United States taxes the earnings of American companies that conduct business abroad. The United States currently taxes corporations on their income at a statutory rate of 35 percent and taxes that income on a worldwide basis.6 However, U.S. tax on overseas income that is earned via foreign subsidiaries is deferred until those earnings are repatriated as dividends to the U.S. parent company. And, when repatriated, the company may take a credit for taxes paid in the foreign jurisdiction, in order to allow the company to avoid double taxation of those earnings.

While there are a number of ways to analyze the tax burden that the Code places on U.S. companies, the easiest gauge for policymakers is to compare the statutory tax rate in the U.S. with that of the other developed countries, as well as the various nations’ tax structures under which companies are taxed. With regard to statutory tax rates, when measured against Organization for Economic Cooperation and Development (OECD) countries, the U.S. currently has the highest rate at 35 percent.7 And, when comparing tax systems within the OECD, at least 28 member countries operate under territorial tax systems “that largely exempt these active [overseas] earnings from home country taxation.”8 Moreover, a comparison with the other countries that comprise the G-8 shows that the U.S. is the only country that continues to tax the income of corporations on a worldwide basis.9 While comparisons of the various tax rates and systems are inherently much more difficult than the simplistic generalities expressed herein, they nonetheless do offer policymakers with a means to evaluate whether, all things equal, the U.S. system of taxation may enhance, or lessen, the competitiveness of U.S. companies in the world economy.

Statistics such as these always provide fodder for policymakers, on both sides of the issue, as they attempt to steer the policy debate over the necessity, and desire, for corporate tax reform. For instance, the Ways and Means Committee Majority staff recently had this to say about our nation’s standing in the world with regard to corporate taxation: “not only does America have the highest corporate tax rate in the developed world (35 percent at the federal level alone), it’s also one of the few countries that tax every dollar companies make—regardless of where they make it.”10 As we’ll discuss later, the combination of the high statutory rate relative to other countries, and the imposition of a worldwide tax on the income of U.S. multinational companies, may be a driving factor in corporate inversion transactions. Those transactions, in turn, may eventually propel Congress to act, as policymakers seek to enhance the competitive position of U.S. businesses in the global economy.

Inversion Transactions – a Response to the Current U.S. Tax SystemWhen policymakers talk in terms of the corporate tax code and its impact on U.S. business, the most recent focus has been centered on corporate inversion transactions, and whether such transactions are a byproduct of the current manner in which the U.S. taxes businesses that operate globally. To understand why Congress is interested in inversion transactions, one must first have a basic understanding of what an inversion transaction is, and the result that may flow from a company “inverting.” While there are a variety of definitions of a corporate inversion, basically it involves “a process by which an existing U.S. corporation changes its country of residence.”11 The result of a typical inversion transaction is that the company that was once a U.S. based entity, now becomes either a non-U.S. based company or a subsidiary of a non-U.S. based company.

6 This simplistic focus on the statutory rate does not take into consideration myriad inputs that are utilized to arrive at a company’s effective tax rate, which in many instances is much lower than the statutory rate.7 http://taxfoundation.org/article/oecd-corporate-income-tax-rates-1981-2013.8 Business Roundtable, Taxation of American Companies in the Global Marketplace: A Primer, April 2011.9 The G-8 countries include Canada, France, Germany, Italy, Japan, Russia, United Kingdom, and the United States.

10 The Committee on Ways and Means, The Lowdown on Inversions, August 18, 2015 (blog).11 Corporate Expatriation, Inversions, and Mergers; Tax Issues, Donald J. Marples and Jane G. Gravelle, Congressional Research Service, May 27, 2014.

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Once a U.S. based company engages in an inversion transaction and, subject to the inverted company meeting certain current law ownership and other requirements, it becomes domiciled in a foreign jurisdiction.12 With many countries outside of the U.S. having already moved to a territorial tax system, whereby companies are (generally) taxed only on the income that they earn within that country’s borders, an inversion transaction may reduce the U.S. tax burden on overseas earnings by the former U.S. company.13 Moreover, for those U.S. companies that have cash trapped overseas, an inversion transaction may allow the company to access that cash by eliminating U.S. tax liability (as no longer subject to the worldwide reach of the U.S.)14 In fact, with the amount of earnings of U.S. multinationals kept overseas now exceeding $2.1 trillion, there is serious concern that, absent tax reform, these earnings will never return to the United States, and in fact could lead to further erosion of our tax base as access to those funds may drive American companies to invert.15 This sentiment was expressed by the Administration in 2014, when Robert Stack, Deputy Assistant Secretary (International Tax Affairs), U.S. Department of the Treasury, stated in testimony before the Senate Finance Committee:

“I want to emphasize the serious need for the United States to once again directly address the potential loss of federal tax revenues from corporate inversion transactions. Letting our corporate tax base erode through inversions will worsen our fiscal challenges over the coming years. Once companies invert, there is a permanent loss to the U.S. income tax base …”

The urgency with which policymakers discuss inversion transactions would lead one to believe that a mass exodus is underway as American companies move their domiciles to more favorable tax jurisdictions. According to the Congressional Research Service, from 2004 to 2014, 47 U.S. corporations engaged in an inversion transaction to re-incorporate overseas.16 Of those transactions, 30 occurred or were announced in the last five years (up to November 2015).17 Whether these numbers imply an exodus is underway, they have caused policymakers, and others, to take notice. One constant among policymakers is the necessary maintenance of a stable tax base, and the inversion transactions that have occurred, and those that are likely to follow, have raised concerns about the potential for a substantial erosion of our corporate tax base.18

The Policy Response to Corporate InversionsWhile inversion transactions are a source of major concern within both parties in Congress as well as the Obama administration, the response to addressing such transactions takes differing paths. The Obama administration, and a number of members of Congress, would take a more targeted approach, focused on the transactions themselves, to make engaging in an inversion transaction less attractive. For instance, in September 2014, the Treasury Department/IRS, released Notice 2014-52, announcing the administration’s plans to address inversion transactions in order to both reduce the tax benefits that could accrue to firms that invert and, if possible, to stop such transactions from occurring in the first place.19 In the

16 U.S. House of Representatives-Ways and Means Committee Democrats, New CRS Data: 47 Corporate Inversions in Last Decade, July 7, 201417 Joint Committee on Taxation, Present Law and Selected Policy Issues in the U.S. Taxation of Cross-Border Income, March 17, 201518 Ranking Member Sander Levin (D-MI), when introducing H.R. 4679, the Stop Corporate Inversions Act of 2014, stated: “Corporate inversions are a growing problem, costing the U.S. tax base billions of dollars and undermining vital domestic investments.” House Ways and Means Committee Democrats, House Democrats Introduce Legislation to Tighten Restrictions on Corporate Tax Inversions, May 20, 2014.19 U.S. Department of the Treasury, Treasury Announces First Steps to Reduce Tax Benefits of Corporate Inversions, Washington, D.C., September 22, 2014.

12 Ibid. Failure of the inverted company to meet certain business activity and/or ownership requirements under current law may subject the company not only to potential tax consequences, but also could cause the new foreign parent company to be treated, for tax purposes, as a U.S. corporation, essentially invalidating the inversion for tax purposes.13 It must be noted, however, that income that an inverted company earns in the United States still remains subject to tax under U.S. law.14 Another important byproduct of an inversion transaction is the potential for a former U.S.-based company to reduce its effective tax rate in the U.S. through earnings stripping, whereby the remaining U.S.-based business incurs significant debt and allowing the company to take a deduction for the interest payments on that debt. See Corporate Inversions and the need for United States corporate tax reform, Who’sWhoLegal, September 2015.15 U.S. House of Representatives Committee on Ways and Means, The Lowdown on Inversions, August 18, 2015.

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absence of any perceived Congressional progress on addressing inversion transactions, the administration sought to chill such transactions in a manner that did not require Congressional approval. And, while the Treasury Notice may have helped to forestall inversion transactions, policymakers and others are not fully convinced that a legislative solution is not also required.20

In addition, on November 19, 2015, the Treasury Department/IRS released Notice 2015-79, announcing the administration’s intent to issue additional regulations that take further steps to expand the scope of the inversion rules and limit the benefits of inversions.21

These efforts by the administration have also been accompanied, over the past several Congresses, by legislation introduced by several Democratic Members of Congress, in both the House and the Senate, that seek a legislative solution that would impose greater restrictions on companies that attempt to invert. In general, the legislation would impose targeted changes to the Code that would seek to discourage companies from attempting to invert, and making it difficult for them to re-domicile in a different country to take advantage of lower tax rates, while still retaining corporate control. The overriding goal of both the administration and these members are the same—to slow or stop the occurrence of inversion transactions.22

However, a bipartisan group of leading members of the tax-writing committees would take a different path forward to address corporate inversions, focusing on tax reform as the means for encouraging companies to remain in the United States. For instance, Senate Finance Committee Chairman Orrin Hatch (R-UT), and Ranking Member Ron Wyden

(D-OR), issued a joint statement following the Treasury Department’s announcement in 2014 that it intended to issue guidance on inversion transactions:

“It’s a very real problem that would best be resolved through a comprehensive overhaul of the tax code that includes dropping the corporate tax rate to 25 percent, shifting the U.S. to a territorial tax system, and implementing smart safeguards to prevent further corporate income tax base erosion.”– Sen. Hatch (R-UT)

“Such actions can and should be done consistent with comprehensive tax reform. Congress should move a bipartisan bill in the lame duck session as an immediate action to address inversions, to create incentives so businesses will remain in or move to the U.S., and to use that legislation as a springboard to comprehensive tax reform.”– Sen. Wyden (D-OR) 23

The current speaker of the House, Paul Ryan (R-WI), has also expressed his preference for engaging in tax reform as a means for addressing inversion transactions, versus the more targeted approach favored by the administration. In a question and answer session with The Wall Street Journal, in July of 2014, he had this to say in response to the question of whether a short-term change was needed to stop inversions:

23 Senate Committee on Finance, Wyden, Hatch Comments on Corporate Tax Inversions, September 22, 2014.

20 Senate Finance Committee, Amid Inversion Talk, Hatch Calls for Internationally Competitive Tax Code to Keep Job Creators in U.S., May 8, 2014. In a speech on the Senate floor, Sen. Hatch expressed his view that corporate tax reform is a better way to address inversion transactions than is legislation targeted at such transactions.21 U.S. Department of the Treasury, Treasury Announces Additional Actions to Reduce Tax Benefits of Corporate Inversions, Washington D.C., November 19, 2015.22 See, S. 198 and H.R. 415, the Stop Corporate Inversions Act of 2015 (Durbin, D-IL and Levin, D-MI); and S. 174 and H.R. 297, the Stop Tax Haven Abuse Act (Whitehouse, D-RI and Doggett (D-TX). The Durbin/Levin legislation would broadly follow the Treasury Department Notice 2014-52, wherein Treasury describes the regulation it intended to issue to target the tax treatment of certain corporate inversions, for inversions that closed after September 22, 2014.

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“As I have said publicly on multiple occasions, I am greatly concerned about corporate inversions. Ultimately, the best way to solve this problem will be to reform our corporate and international tax system in a manner that will make our multinationals competitive against their foreign counterparts.”– Chairman Orrin Hatch - Statement at Finance Committee

Hearing on International Taxation, July 22, 2014.

Early in the 114th Congress, a two-step process was emerging as the means for achieving fundamental tax reform. The initial step would focus on corporate and international tax reform; areas where there was some commonality with the Obama administration on the need, if not necessarily the means, for moving forward. The second step, focusing on small business and individual reform, would be postponed awaiting a new administration, in the hopes that the next administration would be more hospitable to Republican views regarding individual-focused tax reform.

While the process sounded simple, a focus on corporate-only tax reform as the first step would have excluded those businesses that are not C corporations, but are structured as pass-through entities where taxation of earnings are passed through to the individual owners. As expected, small business interests that would have been in the second step of that two-step process were swift in their condemnation of the idea. For instance, the Coalition for Fair Effective Tax Rates, whose members include leading small business advocacy groups, purportedly wrote on April 15, 2015, to the Chairmen of the Finance and Ways and Means Committees that “we cannot support an approach to tax reform that does not help pass-through entities as well as C Corporations.”25 The concern was that the second step might never occur, and if tax reform is truly a once-in-a-generation undertaking, being a part of the “next” generation that benefits therefrom, was

“It’s very clear that the solution here is tax reform. Because if we try to do some short-term patch, all we’ ll end up doing is accelerating the trend of foreign companies buying U.S. companies. So we will actually make problems worse, we will make things worse off, and we will lose even more US companies.” 24

Whether the focus is targeted, or broad, policymakers for several years now have significantly raised the profile of this issue. And, while members may disagree on the solution, the one thing they do agree upon is the proposition that corporate inversions, in the end, may result in an erosion of our corporate tax base, and the loss of other tangible and intangible benefits when a company inverts. That perception, regardless of validity, can be the driving force that leads Congress to act on tax reform.

Corporate-Only Tax Reform to Address Inversion Transactions?While policymakers may differ in their views regarding the best means for addressing inversion transactions, there is consensus among key members of Congress that the best way forward is a broad reform of the Code that brings the U.S. tax system more in line with the rest of the developed world. In their view, fundamental tax reform that makes the U.S. a more tax-friendly jurisdiction for U.S. companies that compete globally not only makes U.S. companies more competitive vis-à-vis their foreign competitors, but also makes the U.S. itself a more hospitable place for foreign-based companies to consider. For instance, Senate Finance Committee Chairman Orrin Hatch stated the following at a hearing on international tax reform in 2014:

24 Wall Street Journal, Paul Ryan on Immigration, Inversions, Impeachment and 2016, July 30, 2014.

25 See, http://thehill.com/policy/finance/238632-chairmen-ask-for-biz-help-in-tax-reform and http://thehill.com/policy/finance/238958-biz-groups-disappointed-with-gop-on-tax-reform. The letter from the Coalition was in response to a joint letter by Chairman Hatch (R-UT) and then Chairman Ryan (R-WI), referenced in the link above, seeking input from members of the Coalition for Fair Effective Tax Rates as to how best to lower the effective tax rate on pass-through entities until such time as a reduction the statutory tax rate became feasible.

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an unacceptable possibility. With small business seemingly not on board with corporate-only reform as a first step, that option never moved forward with serious consideration.26

The Solution – Fundamental Tax ReformWhile Congress has been unable to move forward this year, even in a piecemeal fashion, to address corporate inversions, such transactions themselves continue.27 In fact, it is anticipated that the Treasury Department is likely to take further steps in the near future to address inversions, mostly due to the inability of Congress to act.28 However, most policymakers maintain that it is incumbent upon Congress to craft a legislative solution to slow, or even stop those transactions that are based primarily on tax considerations.

While the rhetoric will continue regarding the need to act to stop inversion transactions, the reality is that Congress is unlikely to move forward with a legislative solution in 2016, primarily because of the impending presidential and congressional elections in November. However, when the 115th Congress convenes in January 2017, and the new president is sworn into office shortly thereafter, many of the necessary parts will be in place for tax reform to move forward and hopefully to completion. First of all, Congress will have the issue that may be necessary to drive fundamental tax reform to completion—corporate inversion transactions. There is certainly bipartisan concern regarding such transactions, and a shared goal of addressing them via legislation. Second, the work that the Ways and Means Committee and the Finance Committee each undertook during the past several Congresses have laid a solid foundation upon which the

115th Congress can act. This foundational work includes not only actual legislative language from the H.R. 1, but also important estimated revenue impacts for the legislation’s proposed changes. While the next Congress will likely not take up the Camp draft in its entirety, nonetheless the existing language and scoring will prove beneficial in crafting a new tax reform proposal.

So, the bottom line is this: when Congress does act on tax reform, and we believe it will, corporate inversion transactions may be the overriding reason for doing so. However, to address such transactions, Congress will likely look to engage in fundamental tax reform, rather than a targeted approach focused only on corporate inversions. The reasoning is simple. In addressing corporate inversions, one of the key provisions in a reform package is likely to be a reduction of the corporate tax rate, to bring the U.S. more closely in line with other developed countries (this in addition to moving to a territorial system for U.S. multinational companies). Yet, reducing the corporate tax rate will be difficult politically unless pass-through entities, where business income is taxed through the individual income tax code, receive similar treatment. As Congress expands its effort to include relief for pass-through entities, it thus becomes a comprehensive undertaking affecting both businesses and individuals. The process, in the end, is likely to result in a product that is a comprehensive reform of business and individual tax code provisions.

With that in mind, it may be time to dust off H.R. 1 from the 113th Congress. While the Camp tax reform proposal was not warmly embraced by all, nonetheless it does provide a starting point from which the 115th Congress can learn, and hopefully move forward, in crafting a new tax reform proposal that achieves the dual goal of simplifying the Code for businesses and individuals, while simultaneously making the U.S. a more attractive place for multinational corporations to call home.

The time may be right to successfully conclude this once-in-a generation tax reform undertaking, and while it may be driven by a need to address corporate inversions, the end result will likely be much broader in its reach.

26 Most recently, bipartisan discussions between former Chairman Ryan, and Senators Schumer (D-NY) and Portman (R-OH) were even more narrowly focused on international reform only, as a means for unlocking the overseas earnings of U.S. multinationals to help provide long-term funding for transportation and infrastructure projects. Those discussions are ongoing, but did not lead to any resolution prior to consideration of highway funding legislation in November, 2015.27 http://fortune.com/2015/10/29/pfizer-allergan-tax-inversions/.28 For instance, on November 4, 2015, Politico reported that the Treasury Department was exploring earnings stripping as a possible regulatory response to inversions, in addition to its continued work on broader inversion regulations announced in Notice 2014-52. See, https://www.politicopro.com/tax/whiteboard/2015/11/pro-tax-inversions-odonnell-063253.

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29

ARE EMERGING MARKET FOREIGN CURRENCIES FINALLY ATTRACTIVE?

IntroductionEmerging market foreign currencies (EMFX) have sold off dramatically in the past two years since the 2013 Taper Tantrum.1 Accounts in the financial media often center on the role of the strong U.S. dollar, sensitivity to developed market (DM) monetary policy, or the fall in commodity prices. In this paper, we try to answer the question of whether or not, after the recent sell-off, are EMFX finally at attractive levels.2 We do this by presenting our long-term and medium-term framework for analyzing currencies. We first apply it to EMFX as an aggregate, and argue that EMFX is beginning to look compellingly attractive by both long-term and medium-term valuation standards. On a long-term basis, EMFX real effective exchange rates (REERs)3 have adjusted significantly, and are now well below long-term averages. Our medium-term framework shows EMFX to be 1.2 standard deviations cheap compared to “fair value”, a level of undervaluation greater than that seen during the Global Financial Crisis. We gauge these findings against terms of trade, changing country fundamentals and global factors. Finally, we use our frameworks to identify potential winners and losers in the EMFX sell-off.

Are Emerging Market Foreign Currencies Finally Attractive?

AUTHORS

1 The Taper Tantrum refers to an episode of financial market volatility, between May and August of 2013, surrounding the approximately 100 basis point surge in U.S. Treasury yields following comments by then Federal Reserve Chairman Ben Bernanke about how the Fed might slow down, or taper, the rate of its bond purchases in its quantitative easing program.2 This paper is designed to explain our methodology for analyzing currencies as part of our investment process and is not meant as a solicitation to engage in currency trading.3 Real Effective Exchange Rate (REER) is a measure of the trade-weighted average exchange rate of a currency against a basket of currencies after adjusting for inflation differentials with regard to the countries concerned and expressed as an index number relative to a base year.

JENS NYSTEDT, PH. DManaging Director

TEAL EMERYSenior Associate

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Frameworks for analyzing FX valuationLONG TERM: PPP AND REERTo assess long-term equilibrium exchange rates, we looked at the deviation of the real effective exchange rate (REER) from its 10- and 20-year averages, as well as its 15-year trend. The Bank for International Settlements (BIS) calculates the most complete monthly series for the REER for 61 countries.4 The REER is driven by the effective (trade-weighted) nominal exchange rate deflated by price levels. The intuition behind this tool is underlined by the theory of Purchasing Power Parity (PPP) derived from the Law of One Price, and postulates that an identical good in two different countries should sell at the same price when expressed in a common currency. Naturally, there are deviations from PPP in the short- and medium-term due to market frictions, transportation costs, and tariffs, among other factors. However, PPP is considered to be a good indicator of exchange rate in the long run, and as such, should provide a valuable insight into under/over-valuation of currencies. There are both sustainable and unsustainable drivers of REER appreciation and depreciation. For example, REER appreciation can be driven by high inflation, driving up prices in an economy compared to its trading partners. This will make the economy uncompetitive, and will likely lead to both nominal and real effective depreciation over time to restore the economy’s external balance. On the other hand, the REER appreciation can be driven by increases in productivity, which would be more sustainable. In sum, our team considers deviations from long-term REER averages and trends to be a useful starting point for deeper discussions about long-term trends in an economy’s overall competitiveness and exchange rate outlook.

MEDIUM TERM: FEER AND BEERWhile considerable empirical evidence backs PPP-based approaches in the long term, economists have spent significant effort creating exchange rate models that assess equilibrium

exchange rates over shorter intervals, with mixed success. The two main schools of these medium-term models are Fundamental Equilibrium Exchange Rate (FEER) models, and Behavioral Equilibrium Exchange Rate (BEER) models.5 FEER models are based on current account reversion, and require the estimation of a sustainable level of current account, as well as other structural parameters that are difficult to ascertain, particularly in the context of emerging markets. We instead prefer to base our approach on BEER style models.

In particular, our approach expands upon the BEER methodology outlined in Clark and MacDonald (1998) and subsequent papers. This approach, in its simplest form, finds an equilibrium exchange rate given long-term statistical relationships with key fundamentals such as terms of trade, productivity and net foreign assets. From the perspective of EM market participants, a key weakness of most academic exchange rate literature is that it uses data that is available at low frequency and with significant lags. Cowan, Rappoport, and Selaive (2007), in a working paper for the Central Bank of Chile, created a high frequency empirical model for the Chilean peso as a policy tool to help the central bank understand and quantify the role of pension funds and central bank interventions in the foreign exchange market. This line of research is further explored and validated in an International Monetary Fund (IMF) working paper by Wu (2013).

Our proprietary Structural Exchange Rate Valuation (SERV) model is a medium-term FX model that seeks to provide a “fair value” for a currency, given its relationship with key structural variables over a multi-year period. Where possible, the model utilizes an interpolated monthly time series of Bloomberg consensus year-ahead forecasts for macroeconomic variables such as GDP growth, fiscal balance, inflation, and current account balance, in order to better capture expectations of market participants. The SERV model also controls for the effect of global variables such as U.S. Treasuries, VIX6 and oil prices. This model allows the team to assess the medium-term SERV “fair value” based on

4 See Turner and Van’t dack (1993), and Klau and Fung (2006) for a more detailed methodological discussion about the compilation and interpretation of the BIS effective exchange rate indices.

5 See Driver and Westaway (2005) for a thorough review of the varieties of equilibrium exchange rate models.6 VIX is the ticker for the Chicago Board Options Exchange (CBOE) Volatility Index, which measures the implied 30-day implied volatility on S&P 500 options. VIX is often used as proxy for overall global forward looking expectations of financial market volatility.

31


consensus expectations of key macroeconomic factors, as well as providing the team with coefficients by which to assess the relative impact of these variables. In turn, when we hold an out-of-consensus view on a particular macroeconomic forecast or global variable, or when we want to test the potential impact of a variety of outcomes, we can plug these assumptions into the model and assess how it may change the SERV “fair value.” Whereas the half-life of PPP has commonly been estimated as being three to five years, the half-life of the SERV model is approximately six months.7

Utilizing the same general methodological framework, we have also developed a short-term Tactical Exchange Rate Valuation (TERV) model, which uses high-frequency variables related to national financial markets, terms-of-trade and global factors to help determine a short-term “fair value”, with a half-life of approximately a week or two. While the TERV is not intended to provide insight into medium- and long-term FX valuations, we actively use this model to complement the medium-term analysis of the SERV and identify tactical opportunities.

EMFX: After the sell-off, are they finally attractive?EMFX REER ADJUSTMENTEMFX has adjusted significantly since the Taper Tantrum on a REER basis. We created an EMFX aggregate based on a EM local market bond index, the JPMorgan Government Bond Index – Emerging Markets Global Diversified Index (GBI-EMGD), weighting. This exercise yielded some interesting insights about EMFX. Following a significant correction during the global financial crisis, the beginning of unconventional monetary policy in developed markets sent money surging into EM assets and contributed to a rapid recovery in the EMFX REER. It reached levels significantly above both long-term averages and above trend, signaling that EMFX had become rich. REERs remained elevated above long-term averages until the Taper Tantrum beginning in May of 2013. Over the following two years, EMFX has adjusted significantly, falling below long-term averages, and significantly lower than its long-term trend.

We can disaggregate this adjustment into two separate episodes that are shown in Display 1. The first episode occurred during the Taper Tantrum and was driven by current account deficit countries. Where unconventional monetary policy had been a key factor driving money into assets of current account deficit countries and driving up REERs, the expectation of the winding down of these policies following Ben Bernanke’s May 2013 speech drove a significant sell-off in the assets of these economies, and a subsequent sharp REER correction. The second episode was driven by energy exporters following the fall in oil prices and the beginning of the USD rally in the summer of 2014.

Display 1: EMFX REER has adjusted significantly since Taper TantrumEMFX

80’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’13’12

85

90

100

105

■ Deviation From Trend (%) REER Trendline

REER

95

-20

-15

-10

10

15

Deviation from

Trend (%)

-5

0

5

’14 ’15

20yr Avg10yr Avg

TaperTantrum

USD/Oil

Past performance is no guarantee of future results. Source: Bloomberg, BIS, JPMorgan and MSIM. Data as of September 30, 2015.

It is worth emphasizing that this REER adjustment means that EM currencies have adjusted significantly, not just against the U.S. dollar, but against their trading partners as well. Furthermore, given the dramatic changes in commodity prices, we tested this REER adjustment against changes in an economy’s terms of trade. We found out that for the majority of EM currencies, the REER adjustment was greater than change in the terms of trade, indicating that the adjustments have not simply been a reflection of changes in commodity prices. As an aggregate, EMFX has adjusted 17.5 percent, while the terms of trade have only fallen by 5.7 percent (see Display 2).

7 In this context, half-life is the time required for a currency misalignment to fall to half its initial value.

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Display 2: EMFX REER adjustment versus terms of tradeAdjustment of REER vs. ToT since the Taper Tantrum

-50-50 -20 -10 0 10 20

REER adjustment (%)30

-40

0

20

30

Term

s of

tra

de (%

) 10

-10

-20

-30

-30-40

ZAR

RONCZK

USD

EURTRY

INR

PLNHUF

IDR

KRW

THB

PEN

PHPCNY

BRL

RUB

CLPMYR

COP

MXN

EMFX

Greater Adjustmentvs. ToT

Deviation from 20-year Avg REER vs. ToT change since the Taper Tantrum

-50-30 -20 -10 0 10 20

% Deviation from 20-year Avg REER30 40

-40

0

20

30

Term

s of

tra

de (%

) 10

-10

-20

-30

ZAR EMFX (Pre TT)

RONCZK

USDEUR

TRY

INR

PLN HUF

IDR

KRW

THB

PEN

PHP CNY

BRL

RUB

CLPMYR

COP

MXN

EMFX

Greater Adjustmentvs. ToT

Past performance is no guarantee of future results. Source: Bloomberg, BIS, Citibank, JPMorgan, and MSIM. Data as of September 30, 2015.

EMFX ADJUSTMENT THROUGH THE LENS OF THE SERV MODELThe significant adjustment in EMFX can also be seen in our medium-term SERV model as illustrated in greater detail in Display 3. The SERV model allows us to look at the effect of expectations of country-specific fundamentals and global factors on medium-term equilibrium exchange rates. While we normally use the model to look at specific currency valuations, an examination of the GBI-EMGD weighted average provides useful insights. When we simply use the Bloomberg consensus forecasts EMFX, as an aggregate, is now 1.6 standard deviations undervalued, with a weighted average R square of .91. When we adjust for our analysts’ more bearish macroeconomic expectations, EMFX still

looks 1.2 standard deviations undervalued.8 As illustrated in Display 3, this is a relatively strong signal compared to recent history that EMFX is becoming cheap, controlling for both changing macro fundamentals and global factors.

Display 3: Using consensus forecasts, SERV indicates EMFX is looking undervaluedSERV indicates EMFX is “cheap” by historical standards

-1.0’08 ’11 ’12 ’13 ’14 ’15

-0.5

1.5

2.0

z-sc

ore

of m

isal

ignm

ent (

+= c

heap

)

1.0

0.5

0.0

’10’09

■ Brazil ■ Mexico ■ Chile ■ Colombia ■ Peru ■ Turkey ■ Russia ■ South Africa ■ Poland ■ Hungary ■ Romania ■ Malaysia ■ Philippines ■ Thailand ■ Indonesia EMFX

Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass. Source: Bloomberg, JPMorgan and MSIM. Data through October 30, 2015.

We use the initial model output as a starting point for analysis, but the SERV’s structure allows us to put the model through a variety of scenarios. First, where possible, the model uses interpolated one-year-forward consensus forecasts of key macroeconomic variables such as fiscal balance, current account balance and central bank rates provided by Bloomberg. However, if our team’s analysts have strong convictions about a specific macro variable, they can plug in their own year-forward estimates. A recent example of this is the rapidly changing expectations about macroeconomic fundamentals in Brazil. The structure of the model allows us to plug in our own estimates as soon as new information becomes available, whereas the Bloomberg consensus forecasts may only reflect these new changes in expectations with a lag. For example, a 1 percent of GDP change in Brazil’s year-forward fiscal deficit will impact the Brazilian

8 Source: MSIM, Bloomberg, JPMorgan. Data as of October 30, 2015.

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real (BRL) SERV “fair value” by approximately 5 percent. Similarly, a 100 basis point (bp) change in the central bank policy rate will impact SERV “fair value” by approximately 5 percent. In total, when we plug in our analyst’s year-forward macroeconomic forecasts, the Brazilian real’s misalignment shrinks significantly from 19 percent undervalued to 2 percent overvalued, as shown in Display 4. Beyond expectations about macroeconomic data, we look at the elevated political risk in Brazil related to a high-level corruption scandal involving the ruling party, potential impeachment of the president, and the possible resignation of the finance minister as elements outside the model driving the currency. Importantly, while currently China and commodity prices are key drivers changing forward-looking expectations of macroeconomic fundamentals across EM, the actual macro fundamentals react more slowly and are unlikely to show the amount of contagion that financial variables would suggest. While the misalignment based on Bloomberg consensus estimates shows EM currencies as 1.6 standard deviations undervalued, our analyst-adjusted estimate is 1.2 standard deviations, which is still a relatively strong signal by historical standards, as illustrated in Display 3, but shows that we expect a worse set of macro data than consensus in a number of countries.

Display 4: Brazilian real SERV “fair value” using consensus forecasts and analyst estimates

1.5’10 ’11 ’12 ’13 ’14 ’15

2.0

4.0

4.5

3.5

3.0

2.5

BRL BRL - SERV “fair value”, using consensus forecasts BRL - SERV “fair value” using MSIM forecasts

SERV "fair value" using MSIM forecasts

SERV "fair value" using consensus forecasts

MARKET FX FV FX Z-SCORE

% MISALIGN-MENT R-SQUARE

Using consensus forecasts

3.86 3.24 2.54 19.04 0.95

Using MSIM forecasts

3.86 3.94 -0.31 -2.13 0.95


We can use the SERV model to simulate shocks to global variables. In the context of monetary policy normalization in the U.S., for example, as shown in Display 4, we can use the SERV model to simulate what would likely happen now if we saw a 100 bp spike in U.S. 10-year Treasury yields, as happened during the Taper Tantrum. The change in the SERV “fair value” shows that a number of the most vulnerable currencies during the Taper Tantrum remained vulnerable, such as Turkish lira (TRY), Brazilian real, and South African rand (ZAR). Others should be less vulnerable, such as Indian rupee (INR), Mexican peso (MXN) and Indonesian rupiah (IDR). A GBI-EMGD weighted average of EMFX, however, helps illustrate that the asset class as a whole appears to be less vulnerable to such a shock.

Display 5: SERV model scenario: +100 BP U.S. 10-year Treasury yield shock vs. Taper Tantrum

-20INR

HUFPLN

KRW CZKBRL

-15

5

10

0

-5

-10

■ SERV +100bps UST Shock (forecast) ■ Taper Tantrum (5/21/13 - 8/30/13)

Perc

ent l

oss/

gain

MXNTH

BCNYIDR

EMFX COP

RONPHP

CLP RUBPEN TR

YMYR

ZAR


34


It is important to note, however, that the significant adjustment in EMFX since the Taper Tantrum suggests that starting valuations are already at “cheap” levels. On a z-score basis,10 using our more bearish macro forecasts, EMFX is 1.2 standard deviations cheap to SERV “fair value” and with the U.S. Treasury shock, it would still remain 1.0 standard deviation cheap.11 Hence, the moves, even if less than during the Taper Tantrum, would likely be even less in actuality given the already lower valuations. As we have written about elsewhere, we believe that a “Taper Tantrum 2” is unlikely not only because of lower valuations, but because of better positioning, and the fact that Fed lift-off is not a signal of concerted monetary tightening elsewhere.12

Likely outperformers and underperformers in EMFXEM currencies as an aggregate are undervalued relative to its historical trend, but not always when compared to fundamentals and terms of trade. Our process for assessing possible outperformers and underperformers combines the long-term and medium-term valuations described above, as well as our team analysts’ knowledge of specific country nuances that may affect currency valuation.

We begin by creating a chart to visualize the synthesis of our long-term and medium-term analysis. On the horizontal axis in Display 7, we created a measure of long-term attractiveness by looking at the REER deviation from long-run averages adjusted by the terms of trade. We did this by taking the change in the terms of trade since the Taper Tantrum and subtracting the currency’s deviation from its 20-year average REER. The Korean won (KRW) has had an 18 percent improvement in its terms of trade, while its REER is approximately equal to its 20-year average REER, so it has a highly positive score that puts it on the right side of the chart, indicating it is attractive on a long-term basis. On the other

We can also simulate the potential effect of both positive and negative oil shocks. Comparing the change to SERV “fair values” of a -$10 per barrel shock to July 2015, a month in which oil prices dropped by approximately $10, the model, as shown in Display 5, indicates that EMFX dropped by around 3 percent in both the model and in the period. While the fact that oil producers are particularly sensitive is not surprising, the model provides both a quantitative and qualitative indication of the relative sensitivity. The CEE9 currencies of Hungarian forint (HUF), Polish zloty (PLN), and Romanian leu (RON) are the most likely to outperform with lower oil prices. One limitation of this model is that we are likely catching the effect of other un-modeled variables that are correlated with oil prices. The weakening of ZAR, for example, likely reflects the correlation of other commodities prices with oil, whereas the weakening of TRY may reflect the correlation of global risk appetite with falling oil prices.

Display 6: SERV model scenario: -$10 shock to oil vs. period of actual -$10 drop

-12INR

HUFPLN

KRW CZKBRL

-10

0

2

-2

-6

-8

■ SERV -$10 Oil Shock ■ Actual -$10 drop in oil (6/30/15 - 7/29/15)

Perc

ent l

oss/

gain

MXNTH

BCNY IDR

EMFX COP

RONPHP

CLP RUBPEN TR

YMYR

ZAR

-4

Past performance is no guarantee of future results. Source: Bloomberg, JPMorgan and MSIM. Data through October 30, 2015.

9 Central and Eastern European (CEE) countries is an OECD term for the group of countries comprising Albania, Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania, the Slovak Republic, Slovenia, and the three Baltic States: Estonia, Latvia and Lithuania.

10 A z-score is a statistical measurement of a score’s relationship to the mean in a group of scores. A z-score of zero means the score is the same as the mean. A z-score can also be positive or negative, indicating whether it is above or below the mean and by how many standard deviations.11 Source: MSIM, Bloomberg, JPMorgan. Data as of October 30, 2015.12 See Market Pulse: “Will There be a Taper Tantrum 2 For Emerging Markets Fixed Income” (2015)

35


hand, the Peruvian nuevo sol (PEN) REER is 7 percent above its 20-year average, while its terms of trade have deteriorated by 12 percent, placing it on the left side of the chart, indicating it has not yet sufficiently adjusted on a long-term basis. In sum, the further to the right the currency falls on the chart, the more adjustment it has seen of its REER versus its terms of trade. On the vertical axis, we look at medium-term valuation using the SERV model. We use the fit-adjusted z-score (This is the z-score multiplied by r-square. For more specifics, please see the table in the Appendix.) On this fit-adjusted z-score basis, the MXN at 2.5, and the Malaysian ringgit (MYR) at 2.7 stand out as the most undervalued currencies, whereas the Czech koruna (CZK) is the most overvalued at -1.3. The higher up in the chart the currency is, the greater the undervaluation by our medium term measure.

Using this analysis, we identify potential outperformers, underperformers, and currencies to watch. For example, the Russian ruble’s (RUB) REER has not yet sufficiently adjusted to its massive terms of trade shock, so it shows up on the far left of the chart. Given that the SERV model shows it as being only slightly cheap (near the middle on the Y axis), no compelling medium-term case can be made for the RUB.

Display 7: Finding value in EMFX

-5-20 -10 0 10 20

Long Term (ToT adjusted long-term REER misalignment)30

-4

2

4

5

Med

ium

Ter

m (S

ERV

- z-s

core

*r-s

quar

e)

3

1

0

-3

-30-40

ZAR

RON

CZK

TRY INR

PLN

HUF

IDR

KRW

THB

PEN PHP

CNY BRL

RUB

CLP

MYR

COP

MXN

Greater long term REER adjustment adjusted for change in terms of trade

-1

-2

SERV: More undervalued on a fit adjusted basis

EMFX

Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass. Source: Bloomberg, JPMorgan and MSIM. Data through October 30, 2015. Latest BIS REER data available as of September 30, 2015.

Potential outperformersFLEXIBLE REFORMERS: MXN AND INRMXN and INR have adjusted significantly on a terms of trade adjusted REER basis, as show in Display 7. Furthermore, while market participants’ initial overenthusiasm has moderated, both Mexico and India continue to push through structural reforms. Though Mexico is an oil producer, the country also imports significant amounts of refined petroleum products, meaning that its terms of trade are not significantly affected by the oil price drop.13 Meanwhile, it has seen a significant REER depreciation, which makes its manufacturing exports more competitive. Furthermore, assuming that a Federal Reserve liftoff is associated with growing confidence in U.S. growth, Mexico’s role as a manufacturing platform for the U.S. means that it will benefit directly from that growth. India has taken policy measures that have helped move it out of the most vulnerable EM economies. For instance, under the guidance of Reserve Bank of India Governor Rajan, monetary policy has gained credibility. Also, as an energy importer, its terms trade have improved significantly. The government of Prime Minister Modi has been implementing structural reforms that increase the flexibility and potential growth of the economy. For these reasons, we believe that both MXN and INR have room to appreciate.

TERMS OF TRADE WINNER? KRWThe KRW has seen the largest positive terms of trade shock of any currency in our sample, as seen in Display 2. KRW’s REER is in line with its long-term average, meaning that on a terms of trade-adjusted basis, it stands out from its East Asian peers. While Korea will face the same headwinds as other East Asian economies in terms of slowing Chinese growth, and the slowing growth in global trade, we believe it will outperform relative to its peers given its significant long-term adjustment. We believe that KRW may appreciate in the medium term, if left to its own devices, i.e., without significant intervention or further weakness in the Chinese yuan (CNY) and Japanese yen (JPY).

13 While this means that the oil price is roughly neutral for the terms of trade, oil revenues are important for the federal budget.

36


UnderperformersPEGGERS AND INTERVENERS: CNY AND PENCurrency policies in both China and Peru have led to CNY and PEN becoming significantly expensive on a long-term basis. While, as a commodity importer, China has benefited from the fall in commodity prices,14 its effective peg to the USD in a period of dollar strength has led to a dramatic appreciation in its REER. While the adverse global reaction to the PBOC’s change in CNY fixing mechanism in August, along with a fear of capital outflows, will likely mean that China will continue to keep the CNY stable in the short to medium term, in the long term, the CNY will need to correct this overvaluation. Meanwhile, Peru’s elevated-level dollarization in the financial system has prompted its central bank to intervene heavily to smooth the path of the PEN to mitigate the balance sheet effects of a weaker currency. As the price of Peru’s main exports have been hit hard, this has meant that the currency has not been able to adjust sufficiently, like it has for neighboring Chile, where the peso (CLP) has been allowed to adjust significantly faster. Both PEN and CNY also look overvalued on a medium-term basis.

OIL, ADJUSTMENT, AND POLITICS: RUBWhile Russia’s REER has adjusted dramatically, it is still smaller than the shock to its terms of trade, meaning that further adjustment is needed. The Central Bank of Russia’s continued easing should also put downward pressure on the ruble. Finally, aside from oil prices, the RUB is vulnerable to significant political risk related to Putin’s potential erratic behavior in the international sphere.

Currencies to watch: MYR, THB, ZAR, TRY, CLP and PLNEach of these currencies has specific idiosyncratic risks, however as a whole, they have begun screening as cheap both on a medium- and long-term basis. While the long-term adjustment is less than our “winners” and the policy narratives are less positive, we believe that there is the potential for value in some of these currencies. Analyst knowledge of country-specific political, economic and financial risks acts as a complement to our valuation tools in assessing where there is real value. Our short-term valuation tools can also help identify opportune tactical entry points in these currencies. We use the fit-adjusted z-score of our short-term valuation models as a key signal to help us identify when a currency may have under- or over-shot its key short-term drivers.

ConclusionIn this paper we have attempted to answer the question of whether, after the sell-off since the start of the 2013 Taper Tantrum, EM currencies are finally attractive. We conclude that EM currencies have started to become compellingly cheap on both a long-term and medium-term basis. Long-term, EMFX REERs have adjusted significantly, and are now well below long-term averages, but in some cases this depreciation is not yet enough to catch up with even more significant terms of trade deterioration. Hence, it is very important to separate potential winners from losers. Winners, in our opinion, are currencies that have seen significant adjustment to their REERs on a terms-of-trade adjusted basis, and whose SERV “fair value” is sufficiently attractive on a medium-term basis. We identify MXN and INR as currencies that we think will appreciate in the medium and long term. Conversely, we find the losers to be currencies where monetary authorities have not let the currency properly adjust, such as CNY and PEN, or currencies that have not adjusted sufficiently to compensate for a significant deterioration of terms of trade, like the RUB.

14 In our view, a significant part of the weakness in global commodity prices can be explained by the disappointment in the Chinese growth outlook.

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IMPORTANT DISCLOSURESThe views and opinions are those of the authors as of November 2015 and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. The views expressed do not reflect the opinions of all portfolio managers at MSIM or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.


Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

All indices referenced are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

The JP Morgan GBI-EM Global Diversified Bond Index is an index which tracks local currency government bonds issued by emerging markets.


Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with investments in foreign developed countries. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates.


There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully read the relevant offering document(s).

Past performance is not a guarantee of future performance.


The material contained in this article is current as of the publication date of the article, is intended for informational purposes only and does not purport to address the financial objectives, situation or specific needs of any individual investor. It has been obtained from sources believed to reliable, but Morgan Stanley cannot guarantee its accuracy or complete-ness. The use of this article is not a solicitation, or an offer to buy or sell

any security or investment product. In addition, this material is not an offer, or a solicitation of an offer, to buy or sell securities in the regions and sectors mentioned.

This communication is a marketing communication. It is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. All information contained herein is proprietary and is protected under copyright law.

Morgan Stanley is a full-service securities firm engaged in a wide range of financial services including, for example, securities trading and brokerage activities, investment banking, research and analysis, financing and financial advisory services.








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ReferencesClark, P. B., & MacDonald, R. (1998). Exchange Rates and Economic Fundamentals: A Methodological Comparison of BEERs and FEERs. (WP/98/67). International Monetary Fund Working Paper.

Cowan, K., Rappoport, D., & Selaive, J. (2007). High Frequency Dynamics of the Exchange Rate in Chile. (433). Central Bank of Chile Working Papers.

Driver, R. L., & Westaway, P. F. (2005). Concepts of Equilibrium Exchange Rates. (248). Bank of England Publications Working Paper.

Klau, M., & Fung, S. S. (2006). The New BIS Effective Exchange Rate Indices. BIS Quarterly Review, March

Nystedt, J., Emery, T., Pando, M., & Rosselli, A. (2015). Will there be a Taper Tantrum 2 for Emerging Markets Fixed Income? Morgan Stanley Investment Management Market Pulse

Turner, P., & Van’t Dack, J. (Eds.). (1993). Measuring International Price and Cost Competitiveness (No. 39). Bank for International Settlements, Monetary and Economic Department.

Wu, Y. (2013). What Explains Movements in the Peso/Dollar Exchange Rate? (13/171). International Monetary Fund Working Paper.

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Appendix

SERV Fair Values

SPOTSERV FAIR

VALUE Z SCOREMISALIGNMENT

(%) R SQUAREFIT ADJUSTED

Z-SCOREFIT ADJUSTED

MISALIGNMENT (%)

MYR 4.30 3.79 2.98 13.38 0.89 2.65 11.90

MXN 16.50 15.20 2.82 8.57 0.87 2.46 7.47

COP 2896.60 2634.98 1.86 9.93 0.90 1.68 8.98

CLP 691.41 624.99 1.64 10.63 0.92 1.51 9.76

IDR 13684.00 12858.74 1.41 6.42 0.95 1.34 6.13

THB 35.62 32.94 1.34 8.16 0.76 1.02 6.22

TRY 2.92 2.62 1.34 11.39 0.96 1.29 10.96

ZAR 13.82 12.94 1.32 6.81 0.96 1.27 6.55

PHP 46.85 44.39 1.31 5.53 0.83 1.09 4.61

INR 65.27 60.47 1.24 7.93 0.80 0.99 6.35

EMFX 1.19 5.95 0.91 1.08 5.44

KRW 1140.54 1105.95 0.61 3.13 0.80 0.49 2.51

PLN 3.86 3.72 0.48 3.70 0.92 0.44 3.40

RUB 63.95 63.39 0.07 0.90 0.92 0.06 0.82

PEN 3.29 3.30 -0.18 -0.53 0.87 -0.15 -0.46

BRL 3.86 3.94 -0.31 -2.13 0.95 -0.30 -2.02

HUF 282.16 286.68 -0.37 -1.58 0.94 -0.35 -1.48

RON 4.03 4.12 -0.44 -2.11 0.98 -0.43 -2.06

CNY 6.32 6.54 -1.19 -3.36 0.68 -0.81 -2.29

CZK 24.62 25.56 -1.42 -3.68 0.95 -1.34 -3.48

Source: MSIM, Bloomberg, JPMorgan. Data as of October 30, 2015.

40


In 2008, the market collapse inflicted huge damage on institutional portfolios. However, the ultimate impact was nothing compared to what would have transpired had the market not subsequently enjoyed such a powerful and continuing rebound. For many long-term portfolios, one of the greatest concerns is the prospect of future drawdowns so severe—and so extended—that they could fundamentally disrupt the planned process of asset management. Even if not explicitly stated, the implicit need to minimize the prospect of such extreme drawdowns may play a key role in shaping a portfolio’s risk structure. To study this drawdown effect on diversified portfolios, we take as a model allocation the Cambridge Associates 2000 to 2014 data for U.S. University endowment funds with assets greater than $1B.

Our basic findings are that 1) rather than diversifying, the so-called diversifying assets actually exacerbated the most severe fund drawdown over this period, 2) this counterproductive behavior of diversifying assets is intrinsic to their structure and is likely to be repeated in major market corrections, 3) over 2000 to 2014, these diversifying assets have provided more than compensatory levels of incremental return, and 4) standard volatility measures do not truly account for the prospect of such drawdown risks.

One of the best defenses against drawdown risk is the accumulation of incremental returns over time. Thus, over the long term, these “diversifying” assets should perhaps be viewed not as risk reducers, but rather as a source of incremental return for investors that can tolerate adverse markets (adverse markets that would hopefully be temporary, respond positively to policy actions, and ultimately be followed by substantial rebounds within a reasonable recovery time!).

However, even a determinedly long-term investor must live through short-term problems associated with adverse markets, especially ones that could be more

Portfolio Strategy: The Diversification Myth and Volatility Failure

AUTHORS

MARTIN LEIBOWITZManaging Director Morgan Stanley Research

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.

ANTHONY BOVA, CFAExecutive Director Morgan Stanley Research

41

PORTFOLIO STRATEGY: THE DIVERSIFICATION MYTH AND VOLATILITY FAILURE

prolonged than the 2008 event. This problem is especially acute for diversified funds with large allocations to assets that are vulnerable to stress beta surges. The resulting potential for greater-than-expected drawdowns may actually represent one of the most significant risks for such funds. However, this risk may not be adequately appreciated because standard volatility measures fail to properly gauge the prospects for extreme drawdowns driven by beta surges.

SummaryWe thank Dr. Stanley Kogelman (who is a not a member of Morgan Stanley’s Research Department) for his important contributions to the development of the mathematics and the research in this report. Unless otherwise indicated, his views are his own and may differ from the views of the Morgan Stanley Research Department and from the views of others within Morgan Stanley.

In 2008, the market collapse inflicted huge damage on institutional portfolios. However, the ultimate impact was nothing compared to what would have transpired had the market not subsequently enjoyed such a powerful and continuing rebound. For many long-term portfolios, one of the greatest concerns is the prospect of future drawdowns so severe—and so extended—that they could fundamentally disrupt the planned process of asset management. Even if not explicitly stated, the implicit need to minimize the prospect of such extreme drawdowns may play a key role in shaping a portfolio’s risk structure. To study this drawdown effect on diversified portfolios, we take as a model allocation the Cambridge Associates 2000 to 2014 data for U.S. University endowment funds with assets greater than $1B.

Our basic findings are that 1) rather than diversifying, the so-called diversifying assets actually exacerbated the most severe fund drawdown over this period, 2) this counterproductive behavior of diversifying assets is intrinsic to their structure and is likely to be repeated in major market corrections, 3) over 2000 to 2014, these diversifying assets have provided more than compensatory levels of incremental return, and 4) standard volatility measures do not truly account for the prospect of such drawdown risks.

The worst drawdown occurred in the last half of 2008, when US equity had a -29 percent return and the typical large endowment fund suffered a -26 percent return. In this very

bad half-year, the sub-portfolio of traditional assets—U.S. equity (USE) and fixed income (FI) had a combined return of -16 percent, while the sub-portfolio of “diversifying” assets experienced the same -29 percent return as U.S. equities. Since these diversifying assets—international developed equity (non-USE), emerging market equity (EME), private equity (PE), real estate (RE), and hedge funds (HF)—had grown to over 75 percent of the overall fund by 2008, it can be said that they were largely responsible for the portfolio’s -26 percent return. (It should be noted that the allocation to these diversifying assets remained close to this same 75 percent level from 2008 through 2014).

In this report, we shall try to better understand: 1) why the diversifying assets failed to diversify in the 2008 debacle, 2) to what extent this failure is endemic to these assets, 3) what are the implications for the risk/reward characteristics of these assets, and 4) what are the implications for the standard volatility projections as a gauge of this form of portfolio risk?1. The diversifying assets did reduce the portfolio volatility—

at least in normal markets. However, in critical times like 2H08, the extreme instability of their beta sensitivity to equity movements led to diversification failure. On a trailing eight-quarter basis, the USE/FI assets had a beta sensitivity that remained quite close to 0.55 throughout the entire 2000 to 2014 period. In contrast, the betas of the diversifying assets started at 0.4 in 2002, rose to 0.9 in 2008, and then declined back to 0.4 by 2014.

Thus, the diversifying assets exacerbated the worst drawdown because their beta sensitivity to equity movements peaked at just the wrong time—when equity values themselves were plunging!

2. The diversifying assets’ 2008 surge in beta sensitivity was not, as commonly thought, the result of an increased correlation with equities. With the correlation already at 90 percent in normal times, there was little room for a sufficiently large increase that could account for such a sizable beta surge. Rather, it was the volatility of these assets as a group that rose even faster than the underlying equity volatility.

If this phenomenon occurs again in an adverse equity market, then with the diversifying assets still at a 75 percent allocation, these diversified portfolios could once again experience nearly the same decline as equities themselves.

42


3. Over the entire 2000 to 2014 period, the diversifying assets had an average return of 6.7 percent compared to 5.4 percent for US equities and 5.1 percent for the traditional US equity/FI core. Thus, the diversifying assets provided an average incremental return of around 1.6 percent, with the bulk of the better returns achieved in the earlier 2000 to 2007 years. Indeed, it was this significant incremental return, rather than any hypothetical (but potentially misleading) risk-reducing property, that primarily accounted for these assets growing to a 75 percent allocation weight. Over the 14 years, this 1.6 percent incremental return has more than made up for the diversifying assets’ -26 percent fall in 2008.

Thus, over the long term, these “diversifying” assets should perhaps be viewed not as risk reducers, but rather as a source of incremental return for investors that can tolerate adverse markets (adverse markets that would hopefully be temporary, respond positively to policy actions, and ultimately be followed by substantial rebounds within a reasonable recovery time!).

4. Over 2000-2008, the average equity volatility was 16 percent, so that a -29 percent 2H08 equity decline had a relatively low probability of occurrence. However, for the overall portfolio, the average volatility was a much lower 11 percent (approximately that of most institutional funds), so that the portfolio’s -26 percent return in 2H08 should theoretically have been much more unlikely. As noted above, this severe drawdown resulted from the diversifying assets’ beta surge at the worst possible time. Such surging behavior is a highly conditional point-in-time event that is generally not incorporated in standard volatility measures (or even in the more common “fat tail” models).

Thus, the standard volatility measures can provide only limited guidance as to the likelihood of an extreme drawdown, one of the most significant risks for long-term diversified funds.

Historical endowment allocationThis study is based on Cambridge Associates data on historical allocations for endowments with assets greater than $1B. Display 1 separates the assets of the largest U.S. endowments into three standard categories—equities, bonds

+ cash, and alternatives—and compares their allocations in 2000 vs 2014. The major change has been higher alternative allocations funded by reduced weightings in equity and fixed income.

Display 1: Cambridge Associates mean endowment allocations

2000 2014

US Equity 34% 16%

Global ex US Equity - Developed Mkts 12 11

Global ex US Equity - Emerging Mkts 3 8

Total Equity 48% 34%

Bonds 18 7

Cash 3 3

Total Fixed Income 21% 10%

Hedge Funds 9 19

Distressed Securities 1 3

Venture Capital & Private Equity 14 18

Real Assets & Inflation-Linked Bonds 6 15

Other 1 0

Total Alternatives 31% 56%

Total 100% 100%

Source: Endowment data as reported to Cambridge Associates LLC, Morgan Stanley Research

The largest U.S. endowment funds usually only report their returns once a year for the fiscal year ending June 30th. In order to perform a more robust analysis of returns and risk measures, a higher-frequency return series is needed. By linearly interpolating the fiscal-year ending weights, a model portfolio with quarterly allocations was developed. Returns for this model portfolio were then estimated by using the index performance data for the various asset classes. This model portfolio can be thought of as a policy portfolio that does not take account of any of the actual funds’ active decisions or alpha generation.

43


Display 2 compares the actual annual returns versus the returns for our hypothetical model portfolio. The returns track closely to one another, with most years having the actual returns slightly exceeding the model portfolio returns.

Display 2: Model endowment portfolio returns vs mean actual endowment returns

-25%

-15%

15%

20%

25%

2001 2003 2005 2007 2009 2011 2013

Model Endowment Portfolio Return Mean Actual Return

-5%

5%

-20%

-10%

0%

10%

Retu

rn


As shown in Display 3, the portfolio had an average volatility of 11 percent from 2000 to 2014 compared to 16.4 percent for the S&P 500. The ratio of the portfolio volatility to S&P 500 volatility has averaged about 67 percent.

Display 3: Standard volatility measures: Model portfolio vs S&P 500

OVER 2000-2014 S&P 500 PORTFOLIOPORTFOLIO/

S&P 500

Average Return 5.4% 5.8%

Average Volatility 16.4% 11.0% 66.9%


The 6-month returns for the model portfolio are plotted versus the S&P 500 returns from 2000 to 2014 in Display 4. The regression line yields a beta of 0.61 with an 83 percent R2. This one-factor beta model does reasonably well at forecasting

the portfolio returns—during normal times. However, in the case of a maximum risk event, this standard beta model does not work well. The maximum drawdown projected by this beta model was -16 percent while the actual return was -26 percent. This -10 percent return difference was due to the stress beta effect engendered by the maximum risk event.

Display 4: Six-month endowment returns vs S&P 500

-30%

-10%

0%

20%

Port

folio

Ret

urn

-40%S&P 500 Return

-30% 30%

Beta = 0.61R2 = 83%

5%

20%10%0%-10%

-15%

10%

-5%

-20%

15%

-25%

-20%StressEffect-10%

Projected-16%

Max Risk Event-26%{


Display 5 further characterizes the 2008 risk event. Over 2000-2008, the average equity volatility was 16 percent, so that the -29 percent 2H08 equity decline had a relatively low probability of occurrence. However, for the portfolio, the average volatility was a much lower 11 percent (approximately that of most institutional funds), so that the portfolio’s -26 percent in 2H08 should theoretically have been much more unlikely.

Display 5: The 2H08 Event

OVER 2000-2014 S&P 500 PORTFOLIOPORTFOLIO/

S&P 500


Average Volatility 16.4% 11.0% 66.9%

2H08 Returns -28.5% -25.6% 90.0%


44


Traditional and diversifying asset componentsTo delve more deeply into the source of these stress effects, it is helpful to reframe the allocations in terms of traditional and diversifying subportfolios. Traditional assets would include USE/FI—US equity, bonds and cash. Diversifying assets would include all other asset classes as a group. Display 6 compares the allocation of the traditional and diversifying assets in 2000 vs 2014. The traditional assets have declined from 55 percent to 26 percent while the diversifying assets have risen from 45 percent to 74 percent.

Display 6: Traditional and diversifying classification of endowment assets

2000 2014

US Equity 34% 16%

Bonds 18 7

Cash 3 3

Traditional Asset Subportfolio 55% 26%

Global ex US Equity - Developed Mkts 12 11

Global ex US Equity - Emerging Mkts 3 8

Hedge Funds 9 19

Distressed Securities 1 3

Venture Capital & Private Equity 14 18

Real Assets & Inflation-Linked Bonds 6 15

Other 1 0

Diversifying Asset Subportfolio 45% 74%

Total 100% 100%


By combining the allocation data with the performance indices for each asset class, the sub-portfolio returns can be plotted against the corresponding S&P returns. The beta stability of the USE/FI assets can clearly be seen in Display 7 with its very high R2 around the regression line having a beta

value of 0.54. The lack of scatter indicates that the traditional assets’ return is primarily driven by USE. Also, as shown in Display 7, the projected -14 percent return during 2H08 represented a fair estimate for the actual return of -16 percent.

Display 7: Traditional assets’ returns vs S&P 500

-20%

-10%

0%

20%Re

turn

-40%S&P 500 Return

-30% 30%

Beta = 0.54R2 = 97%

5%

20%10%0%-10%

-15%

10%

-5%

-20%

15%

Max Risk Event


Display 8 provides another perspective on the behavior of the USE/FI assets. The ratio of the 2H08 drawdowns for these traditional assets versus the S&P 500 was 56 percent—in line with what would be expected, given the 0.54 beta value in Display 7.

Display 8: Traditional USE/FI assets reasonably well-behaved

OVER 2000-2014 S&P 500TRADITIONAL

ASSETS

TRADITIONAL ASSETS/ S&P 500


Average Volatility 16.4% 9.0%

2H08 Returns -28.5% -15.9% 55.9%


Display 9 plots the six-month returns for the diversifying assets vs the S&P 500. While the overall regression-line beta of 0.63 is not too far from the USE/FI beta of 0.54,

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the diversifying assets exhibit much more scatter around the regression line, resulting in a significantly lower R2 of 73 percent.

Display 9: Diversifying assets’ returns vs S&P 500

-35%

-10%

0%

20%

Retu

rn

-40%S&P 500 Return

-30% 30%

Beta = 0.63R2 = 73%

5%

20%10%0%-10%

-15%

10%

-5%

-20%

15%

-25%

-20% StressEffect

-13%

Projected-16%

Max Risk Event-29%{-30%


The diversifying assets’ variability is clearly evident during the 2H08 event. All of these assets—non-U.S. equity, private equity, real estate, hedge funds—have betas that are highly vulnerable to extreme equity movements. In normal markets, the more moderate betas of these assets can act as “diversifiers.” However, in the depths of the 2008 to 2009 crisis, these beta values—as a group—surged to much higher stress levels. As a result, the actual return for the diversifying assets was -29 percent vs a regression line that projected a -16 percent return.

The diversifying assets’ return behavior during this risk event was almost identical to that of the S&P 500. As shown in Display 10, the 2H08 drawdowns for the diversifying assets and the S&P 500 were almost identical, even though their 2000 to 2014 volatilities were a quite different 12 percent and 16 percent, respectively. Because of the crisis-driven beta surge, the standard volatility metrics understated the behavior of the diversifying assets during this adverse event.

Display 10: Diversifying assets are the key to maximum risk event

OVER 2000-2014 S&P 500DIVERSIFYING

ASSETS

DIVERSIFYING ASSETS/ S&P 500


Average Volatility 16.4% 12.2%

2H08 Returns -28.5% -28.8% 101.1%


Display 11 summarizes the stress beta effect across the different portfolio components. The traditional USE/FI assets did not have a significant stress beta effect as their actual 6-month drawdown was close to their standard beta return projection. In contrast, the diversifying assets had a much worse return than implied by their standard beta projection. Thus, it was the diversifying assets that drove the -10 percent stress beta effect at the portfolio level.

Display 11: “Stress Beta” effect

S&P 500

TRADITIONAL ASSETS

DIVERSIFYING ASSETS PORTFOLIO

2H08 S&P 500 Return

-28.5% -28.5% -28.5% -28.5%

Standard Beta Projection

-28.5% -14.3% -16.3% -16.2%

Actual 2H08 Returns

-28.5% -15.9% -28.8% -25.6%

Stress Beta Effect

0.0% -1.6% -12.5% -9.5%


The behavior of the diversifying assets’ return has important implications for the current structure of endowment portfolios. Display 12 shows trends in the percentage allocation of traditional and diversifying assets. In 2000, the diversifying assets as a group comprised 45 percent of the portfolio. The diversifying assets’ allocation rose steadily over the next eight years, reaching a plateau of 75 percent in

46


2008. Surprisingly, this 75 percent level has been essentially sustained both during the 2008 to 2009 crisis and throughout the post-crisis period from 2010 until 2014.

Display 12: Allocation trends: Traditional vs diversifying

0%

60%

100%

2000 2002 2014

70%

2012201020082006

40%

80%

50%

2004

90%

20%

30%Traditional

10%

Diversifying


With this high percentage of diversifying assets, another adverse market event could again result in severe portfolios drawdowns. At the same time, it should be pointed out that over the entire 2000 to 2014 period, the diversifying assets had an average return of 6.7 percent versus 5.4 percent for U.S. equities and 5.1 percent for the traditional U.S. equity/FI core. Thus, the diversifying assets provided a simple average incremental return of around 1.6 percent over the traditional core. Over the 14 years, this 1.6 percent incremental return more than made up for the portfolio’s -10 percent stress beta effect experienced in 2H08.

ConclusionsIn 2008, the market collapse inflicted huge damage on institutional portfolios. However, the ultimate impact was nothing compared to what would have transpired had the market not subsequently enjoyed such a powerful and continuing rebound. For many long-term portfolios, one of the greatest concerns is the prospect of future drawdowns so severe—and so extended—that they could fundamentally disrupt the planned process of asset management. Even if not explicitly stated, the implicit need to minimize the prospect of such extreme drawdowns may play a key role in shaping a portfolio’s risk structure.

In this study of the 2000 to 2014 endowment returns, our basic findings are that 1) rather than diversifying, the so-called diversifying assets actually exacerbated the most severe fund drawdown over this period, 2) this counterproductive behavior of diversifying assets is intrinsic to their structure and is likely to be repeated in major market corrections, 3) over 2000 to 2014, these diversifying assets have provided more than compensatory levels of incremental return, and 4) standard volatility measures do not truly account for the prospect of such drawdown risks.

On the one hand, one of the best defenses against drawdown risk is the accumulation of incremental returns over time. Thus, over the long term, these “diversifying” assets should perhaps be viewed not as risk reducers, but rather as a source of incremental return for investors that can tolerate adverse markets (adverse markets that would hopefully be temporary, respond positively to policy actions, and ultimately be followed by substantial rebounds within a reasonable recovery time!).

On the other hand, even a determinedly long-term investor must live through short-term problems associated with adverse markets, especially ones that could be more prolonged than the 2008 event. This problem is especially acute for diversified funds with large allocations to assets that are vulnerable to stress beta surges. The resulting potential for greater-than-expected drawdowns may actually represent one of the most significant risks for such funds. However, this risk may not be adequately appreciated because standard volatility measures fail to properly gauge the prospects for extreme drawdowns driven by beta surges.

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DISCLOSURE SECTIONThe information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. LLC, and/or Morgan Stanley C.T.V.M. S.A., and/or Morgan Stanley Mexico, Casa de Bolsa, S.A. de C.V., and/or Morgan Stanley Canada Limited. As used in this disclosure section, “Morgan Stanley” includes Morgan Stanley & Co. LLC, Morgan Stanley C.T.V.M. S.A., Morgan Stanley Mexico, Casa de Bolsa, S.A. de C.V., Morgan Stanley Canada Limited and their affiliates as necessary.

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ANALYST CERTIFICATIONThe following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Martin Leibowitz.

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For disclosure purposes only (in accordance with NASD and NYSE require-ments), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively.

Stock Rating Category

Coverage Universe Investment Banking Clients (IBC)

Count% of Total Count

% of Total IBC

% of Rating Category

Overweight/Buy

1161 35% 321 41% 28%

Equal-weight/Hold

1459 44% 370 47% 25%

Not-Rated/Hold

101 3% 10 1% 10%

Underweight/Sell

609 18% 88 11% 14%

Total 3,330 789

Data include common stock and ADRs currently assigned ratings. Invest-ment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months.

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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.

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Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.

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Anthony Bova, CFAExecutive Director

Anthony is a research analyst on the Global Strategy team at Morgan Stanley Research, focusing on institutional portfolio strategy. He joined Morgan Stanley in 2000 and has 13 years of investment experience. Prior to his current role, Anthony covered commodity chemicals for the Equity Research team. He received a B.S. in economics from Duke University. Anthony holds the Chartered Financial Analyst designation.

Mikhael Breiterman-Loader, CFAVice President

Mikhael is a member of the Global Fixed Income team. He joined Morgan Stanley in 2009 and has six years of investment experience. Mikhael received a B.S.E. in operations research and financial engineering from Princeton University. He holds the Chartered Financial Analyst designation and is a member of the New York Society of Security Analysts.

About the Authors

Jim CaronManaging Director

Jim is a portfolio manager and senior member of the MSIM Global Fixed Income team and a member of the Asset Allocation Committee focusing on macro strategies. He joined Morgan Stanley in 2006 and has 23 years of investment experience. Prior to this role, Jim held the position of global head of interest rates, foreign exchange and emerging markets strategy with Morgan Stanley Research. He authored two interest rate publications, the monthly Global Perspectives and the weekly Interest Rate Strategist. Previously, he was a director at Merrill Lynch where he headed the U.S. interest rate strategy group. Prior to that, Jim held various trading positions. He headed the U.S. options trading desk at Sanwa Bank, was a proprietary trader at Tokai Securities and traded U.S. Treasuries at JP Morgan. Jim received a B.A. in physics from Bowdoin College, a B.S. in aeronautical engineering from the California Institute of Technology and an M.B.A in finance from New York University, Stern School of Business.

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ABOUT THE AUTHORS

Teal EmerySenior Associate

Teal is a member of the Emerging Markets Debt team. He joined Morgan Stanley in 2012 and has six years of industry experience. Prior to this role, Teal was an intern at Morgan Stanley, working on country risk, and at the U.S. Department of the Treasury, in their Office of International Banking and Securities Markets. Previously, he was a paralegal at Cleary Gottlieb Steen & Hamilton LLP. Teal received a B.A. in political economy and Latin American studies from Hampshire College and a Master of International Affairs from Columbia University.

Amay HattangadiExecutive Director

Amay is an investment team member focusing on India. He joined Morgan Stanley in 1997 and has 18 years of investment experience. Previously, he was a portfolio administrator. Amay received a Bachelor of Commerce degree from the University of Mumbai. He is an Associate Member of the Institute of Chartered Accountants of India. He holds the Charted Financial Analyst designation.

Swanand KelkarExecutive Director

Swanand is a portfolio advisor and analyst on the Global Emerging Markets Equity team, focusing on India, based in Mumbai. He joined Morgan Stanley in 2007 and has 11 years of investment experience. Prior to joining the firm, Swanand worked in the equity investment department at HSBC Asset Management. He received his bachelors degree in commerce from the University of Mumbai and an M.B.A. from the Indian Institute of Management, Ahmedabad. Swanand is also an associate member of the Institute of Chartered Accountants of India.

David KempsExecutive Director

David Kemps joined Morgan Stanley in May 2011 and is located in its Government Relations office in Washington, D.C. Through his position, he advocates the company’s interests in tax and retirement issues before Congress and the Executive Branch. From 2004 through 2010, Mr. Kemps served as Vice President of Federal Relations for the Lincoln Financial Group. While at Lincoln, he advocated the company’s interests before Congress and the Executive Branch on a wide range of issues, monitored legislative and regulatory actions with a focus on corporate and product taxation, retirement, and financial services, and directed the company’s political activities over the course of several election cycles. Prior to this, Mr. Kemps served as a government affairs officer for the Investment Company Institute and was manager of Employee Benefits Policy for the U.S. Chamber of Commerce. His policy background also includes work in the government affairs office of the JC Penney Company and on the personal staff of a United States Senator. In the early 1990’s, Mr. Kemps was a practicing attorney in the Office of the General Counsel at the Pension Benefit Guaranty Corporation. Mr. Kemps has spoken frequently at various conferences around the country. In addition, he has also appeared on national television and radio broadcasts and has been quoted in numerous publications including The Wall Street Journal, Pensions and Investments, and Defined Contribution News. Mr. Kemps earned his law degree from The Catholic University of America, Washington, D.C., and his undergraduate and graduate degrees from Ball State University.

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Martin LeibowitzManaging Director

Martin L. Leibowitz is a managing director with Morgan Stanley Research Department’s global strategy team. Over the past eight years, he and his associates have produced a series of studies on such topics as asset allocation, policy portfolios, rebalancing strategies, asset/liability management, and duration targeting in bond portfolios.

Prior to joining Morgan Stanley, Mr. Leibowitz was vice chairman and chief investment officer of TIAA-CREF from 1995 to 2004, with responsibility for the management of over $300 billion in equity, fixed income, and real estate assets. Previously, he had a 26-year association with Salomon Brothers, where he became director of global research, covering both fixed income and equities, and was a member of that firm’s Executive Committee.

Mr. Leibowitz received both A.B. and M.S. degrees from The University of Chicago and a Ph.D. in mathematics from the Courant Institute of New York University.

He has written over 200 articles on various financial and investment analysis topics, and has been the most frequent author published in both the Financial Analysts Journal (FAJ) and the Journal of Portfolio Management (JPM). Ten of his FAJ articles have received the Graham and Dodd Award for excellence in financial writing. In February 2008 an article written by Mr. Leibowitz and his associate Anthony Bova was voted Best Article in the 9th Annual Bernstein Fabozzi/Jacobs Levy Awards by the readers of JPM.

In 1992, Investing, a volume of his collected writings, was published with a foreword by William F. Sharpe, the 1990 Nobel Laureate in Economics. In 1996, his book Return Targets and Shortfall Risks was issued by Irwin Co. In 2004, two of his books were published: a compilation of studies on equity valuation, titled Franchise Value (John Wiley & Co.), and a revised edition of his study on bond investment, Inside the Yield Book (Bloomberg Press). The first edition of Inside the Yield Book was published in 1972, went through 21 reprintings, and remains a standard in the field. A second edition was published in 2008 with a foreword by Henry Kaufman, and a third edition was issued in 2013 with a major new section on Duration Targeting. In 2008, Mr. Leibowitz co-authored a book which focused on active equity strategies, Modern Portfolio Management (John Wiley & Co.). Another

volume, The Endowment Model of Investing, co-authored with Anthony Bova and Brett Hammond of TIAA-CREF, was published in 2010, also by John Wiley & Co. Peking University Press has published a Mandarin edition of The Endowment Model, released in March 2012.

Mr. Leibowitz has received three of the CFA Institute’s highest awards: the Nicholas Molodowsky Award in 1995, the James R. Vertin Award in 1998, and the Award for Professional Excellence in 2005. In October 1995, he received the Distinguished Public Service Award from the Public Securities Association, and in November 1995 he became the first inductee into The Fixed Income Analyst Society’s Hall of Fame. He has received special Alumni Achievement Awards from The University of Chicago and New York University, and in 2003 was elected a Fellow of the American Academy of Arts and Sciences.

Mr. Leibowitz serves on the investment advisory committee of Singapore’s GIC, the Harvard Management Corporation, the Carnegie Corporation, the Rockefeller Foundation, and the Institute for Advanced Study in Princeton, NJ.

Joseph Mehlman, CFAExecutive Director

Joe is a member of the Global Fixed Income team and is the head of U.S. Credit. He joined Morgan Stanley in 2002 and has 13 years of investment experience. Joe received a B.A. with honors in economics from Trinity College. Joe holds the Chartered Financial Analyst designation and is a member of the New York Society of Security Analysts.

Justin MillerSenior Associate

Justin is a portfolio specialist on the Emerging Markets Debt team. He joined Morgan Stanley in 2014 and has 15 years of investment experience. Prior to joining the firm, Justin was a senior investment product analyst at MFS Investment Management. Previously, he was an investment associate at Peak Financial Management, Inc. and a relationship manager at Investors Bank and Trust. Justin received a B.S. in finance from the University of Massachusetts and an M.B.A. in marketing from Northeastern University.

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ABOUT THE AUTHORS

Jens Nystedt, Ph.D.Managing Director

Jens is a portfolio manager and head of sovereign research for the Emerging Markets Debt Team. He joined Morgan Stanley in 2014 and has 17 years of investment experience. Prior to joining the firm, Jens was a chief economist, global strategist and portfolio manager at Moore Capital Management. Previously, he held senior positions at GLG Partners, the International Monetary Fund (IMF) and Deutsche Bank, where he was chief economist for EMEA and head of Local Markets Strategy. Jens holds a Ph.D. in international economics and finance and an M.Sc. in international finance from the Stockholm School of Economics, Sweden.

Marco Spaltro, Ph.D.Vice President

Marco is a portfolio manager and member of the MSIM Global Fixed Income team. He joined Morgan Stanley in 2013 and has four years of investment experience. Prior to joining the firm, Marco was an economist at the Financial Stability Directorate of the Bank of England. While at the Bank, Marco published research on the effects of QE and macroprudential policies on the real economy. Previously, he worked in New York and London as a foreign exchange economist for a financial consultancy firm. Marco received a B.Sc. in economics (summa cum laude) from Catholic University, Milan, an M.Sc. from University College London and a Ph.D. in economics and finance from University of London.

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2016 | Volume 6 | Issue 1

NOT FDIC INSURED OFFER NO BANK GUARANTEE MAY LOSE VALUE

NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY NOT A DEPOSIT

FOR U.S. INVESTORS ONLY

© 2016 Morgan Stanley 1373102 Exp. 12/16/2016 8410657_KC_1215 Lit-Link: MSIMJRNL 01/16

morganstanley.com/im/journal

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