Document 340389

October 17, 2014
Dear Client,
U.S stocks rallied today, providing much needed relief for markets, following accelerated selling throughout the week. After posting six
consecutive trading days of declines, the Dow Jones Industrial Average soared 263 points, or 1.6%. Today’s positive finish comes at
the end of what has been a very volatile week for the markets, as exemplified by four 150 point letters in the last week. The main
catalyst for today’s move came from abroad, as the European Central Bank seemed more likely to increase stimulus measures.
Indeed, an executive board member at the ECB commented that they will begin purchasing assets “within the next days” as part of their
new easing program and a Bank of England official indicated that rates could stay lower for longer. This commentary helped quell
markets which have sold off recently in the wake of slowing Eurozone growth and questions about future ECB policy action.
Economic news out of the US also added a boost to the rally today, illustrating that the US recovery continues to be resilient despite
European growth woes. The University of Michigan consumer confidence index rose in October to the highest reading in about seven
years, beating consensus forecasts. This report is consistent with the MS & Co. economics team’s view of improving consumer
fundamentals driven primarily by gains in aggregate wages and salaries, and further boosted by lower gas prices. Additionally, housing
starts surprisingly rebounded 6.3% in September ahead of economists’ forecast for a 4.6% rise. Lastly, third quarter earnings were off
to a good start this week, with the majority of companies that have reported showing better than estimated results. Today’s risk on
environment was a reversal of the week’s trends when investors mostly sought safe haven assets. The yield on the 10-year U.S
Treasury Note climbed to 2.2% today, though still down for the week.
For the day, all 10 S&P 500 sectors finished in the green with Industrials leading, up 2% followed by Healthcare up 1.6% and Materials
up 1.4%. Utilities gained the least, up 0.6% followed by Energy up 0.9% and Telecom up 1.1%. For the day all three major indexes
gained, with the S&P 500 up 24 points, or 1.3% to close at 1,887, and the NASDAQ up 41 points or 1.0% to 4,258.
Looking ahead, please find below a summary of MS & Co.’s current views for the major asset classes:
MS & Co. chief U.S equity strategist, Adam Parker, maintains a 12-month forward price target of 2,125 for the S&P 500. This
represents roughly 13% potential upside from today’s close. Notably, Adam analyzed previous periods in history when the market P/E
multiple expanded by three multiple points like it has over the last two years from 12x to over 15x forward estimated earnings today and
found that despite an elevated valuation, the market continued to perform well for the subsequent 12-24 months in the three periods in
history in which this scenario occurred (i.e., March 1986 to September 1987, December 1991 to December 1992, and November 1996
to October 2000). Adam has remained positive on the market since March 2013, but recently moved to a more balanced view. Within
his sector recommendations, Adam favors Healthcare and Technology, and is underweight Consumer Staples and Financials. Stockspecific risk has been on the rise in recent months and Adam believes investors should favor a somewhat more concentrated portfolio
approach focusing on stocks with high free cash flow generation, dividend growth, and high earnings achievability.
From an asset allocation perspective, Morgan Stanley Wealth Management CIO, Mike Wilson, and the Global Investment Committee
(GIC) continue to favor equities over fixed income in the medium to long term and see gradual improvement in the global economy. For
example, the GIC tactical model 4 for moderate risk investors is allocated to 50% equity/26% fixed income. Supporting this view, the
GIC notes that equity performance is broadening around the world, with falling correlations among asset classes reflecting the ongoing
growth recovery. The GIC continues to see upside potential in equities in 2014 even as interest rates likely rise gradually, and believes
that selectivity is paramount. Globally, the GIC has remained bullish on Japanese equities since early 2013 and remains positive given
an attractive earnings growth profile, ongoing monetary and fiscal stimulus initiatives from Prime Minister Abe, and likely export-related
gains from yen depreciation. Notably, “Abenomics” seems to be making progress breaking Japan’s 15-year deflationary turmoil as
inflation expectations have risen significantly over the past year. Mike Wilson believes rising inflation in Japan is critical as it impacts
consumer, corporate and investor behavior. While Japanese equities had 30%+ gains last year, the GIC highlights that most of this
move has been driven by foreign investors, which may leave domestic investors as a potential driver of incremental upside.
While emerging market stocks have rallied in recent months, the GIC remains underweight EM because likely higher US interest rates
and a strengthening US dollar could leave emerging market stocks vulnerable. EM economies are rebalancing to domestically driven
demand from export and infrastructure, which will take time, and these economies also remain sensitive to global liquidity withdrawal as
Fed tapering continues. Although EM equities may appear cheap relative to DM equities on a price/earnings basis, the GIC highlights
that the market-cap weighted MSCI EM Index has large weights in cyclical sectors, which likely do not warrant higher valuations.
Despite the recent sell-off in energy the GIC continues to view select MLPs as attractive, particularly relative to other yield-producing
assets and within the context of a 10-year U.S Treasury rate around 2.2%.
From a fixed income perspective, the GIC still recommends below-benchmark duration, which is consistent with the views of Morgan
Stanley Wealth Management fixed income strategists.
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