Deflation: Will America and Europe Follow Japan?

- "Investors are asking whether America and Europe will follow Japan into deflation. We think not. Japan fell into secular deflation because of a unique combination of structural factors. These factors are (a) high central bank independence with low accountability, (b) advanced aging of the population, (c) an electoral system that strongly over-represents the interests of older voters, and (d) a current account surplus that dulls the need for structural reforms."
- "Japan will likely remain in deflation, because none of the structural factors is likely to change soon."
- "The US is unlikely to fall into deflation. The Federal Reserve is more accountable and transparent than the Bank of Japan. The US is young; the electoral system does not over-represent older voters; the current deficit increases pressure for structural reform."
- "Europe is less likely than Japan but more likely than the US to fall into deflation. This is because Europe lies between Japan and the US on the four factors."
- "The best investment strategy is to seek yield and monetary assets in Japan, and seek beta and real assets in the US. Europe falls between the two. Inflation linked bonds are attractive. They provide protection in high inflation countries and high real rates in low inflation countries."
- Risk Scenario - Global Inflation: "In the risk scenario, where common global factors overcome regional differences, all developed economies are likely to tilt toward inflation. Nominal assets in all countries would likely underperform, and real assets outperform. Linkers would be attractive in most countries."

Greater China: Issues in Focus

- China: Moderation Continues "Against the backdrop of the authorities’ redoubled efforts to shut energy-inefficient production units, industrial production growth continued to moderate due to intensified supply-side adjustment. While fixed-asset investment growth saw a further slowdown, tailwinds (e.g. loosening of controls on new projects, aggressive implementation of the social housing program, easing in local government financing) have now appeared. We also expect the Chinese authorities to allow a faster appreciation of the RMB against the USD given the rising political pressure and the prospective large trade surplus in 2H10 compared to 1H10. Given the heightened uncertainties, we have launched the China Macro Risk Radar (CMRR) to provide a framework to systematically assess and monitor risk events of low probability but potentially high impact."
- Hong Kong: Robust Growth and Capital Inflow "The Hong Kong economy sustained robust growth in 2Q10 with real GDP expanded 6.5% YoY. We now expect GDP to grow 6% and 4% in 2010 and 2011 respectively. The Hong Kong banking system saw a significant increase in RMB deposits in July without hurting the growth of HK$ or other foreign currency deposits, signaling a genuine expansion in the banking sector balance sheet upon the further development in the offshore RMB business. We also observed capital inflow in July, and fundamentally the stock of excess liquidity in the banking system still remained sizable, offering little upward pressure on interest rates."
- Taiwan: 2Q GDP Beat Expectations by Wide Margin "Taiwan’s GDP expanded 12.5% YoY in 2Q10, driven mainly by an upside surprise in private consumption growth which should increase the overall economy’s resilience in the event that external demand faces any uncertainties. With the economy expanding faster-than-expected, we believe that interest rate normalization will continue for the rest of the year. We expect two more rate hikes in 2H10 (+12.5 bps each) to bring the policy re-discount rate to 1.625% by year-end."

Back to School: The Credit Market Outlook 2H10

- Keep Calm and Carry On "We are constructive on corporate credit globally, and expect he Asian risk premium over Developed markets to gradually compress. A US growth lowdown to 2% but short of a a double dip, although raising the probability of tail-risks, will eep DM credit in a relative ‘sweet spot’ of low rates and a lid on credit-unfriendly actions, while valuations and liquidity support Asia in spite of ‘equity-friendly’ growth rates."
- Technicals and Valuations support Asia "We expect Asian credit spreads to ncreasingly converge with DM spreads, driven by asset allocation trends, healthy balance heet liquidity and an increasingly reduced emphasis on liquidity premiums."
- The Future of Asian Credit Markets "The Asian credit markets are in the midst of a secular change. Both the demand side and supply side are growing much faster than the historical norm. We expect the next five years to be very different to the past five years and expect the non-Financial credit market in Asia to quadruple in 2015. ."
- Key themes in Asia:
• "Prefer HY over IG, due to unusually steep credit quality curves, shrinking all- in yields, unusually strong corporate liquidity profiles and a supportive cyclical backdrop;
• Prefer China Property within Asian HY, powered by valuations, a policy cycle increasingly on hold and an improving Chinese credit cycle ; and
• Prefer Bank Capital, as regulatory change represents a powerful, credit friendly de-risking trend and valuations still look compelling."
• "Cautious on Australian banks, due to concerns about significant funding needs for 2010-2011 and increasingly bubble-like housing valuations."
• "Uncomfortable with Quasi-sovereign valuations. Global quasi-sovereign valuations are increasingly stretched and Asia is richer than CEMEEA and LATAM. Our Quasi-sovereign score provides guidance."

Morgan Stanley Asia Credit Strategy 20100831

Changing Our H2 US Growth Outlook

- From above- to below-trend growth: "We are downgrading our outlook for second-half growth to 2-2.5% from 3-3.5% previously. This downgrade from above-trend to below-trend growth has important implications for forecasts of the unemployment rate, inflation and monetary policy."
- More slack, lower inflation: "Slack in the economy likely will widen slightly in this new outlook, implying a slower rise in inflation. The unemployment and housing vacancy rates may rise. So while core inflation has bottomed, it may linger below the Fed’s comfort zone for longer."
- The Fed shifts to an easing bias: "At Jackson Hole, Fed Chairman Bernanke clearly indicated that the Fed is prepared to ease monetary policy if needed. The odds of such action are considerably less than certain, however; they will hinge on additional weakness in incoming data."
- Sources of weakness: "Difficult diagnosis: We think the main culprit for weakness relative to our forecast is less than expected support from global growth. But other factors — temporary loss of stimulus measures and hesitation resulting from policy uncertainty — likely also played a role."
- Implications for 2011: "We don’t think this slowdown will last beyond H2, much less morph into a downturn. Policymakers may take action, household balance sheets continue to improve, and we still think net exports will add to growth. We see no reason to downgrade 2011 and even possible reasons to upgrade, especially if policy turns more stimulative."

Morgan Stanley US Economics 20100827

Ask Not Whether Governments Will Default, but How

- "This is the first issue of Sovereign Subjects, a new Morgan Stanley publication focusing on sovereign risk in advanced economies. In this first installment, we take a broad perspective on government balance sheets and raise several themes to which we will return in more depth in subsequent issues. We encourage clients to provide us with feedback on this new publication."
- "Debt/GDP ratios are too backward-looking and considerably underestimate the fiscal challenge faced by advanced economies’ governments. On the basis of current policies, most governments are deep in negative equity."
- "This means governments will impose a loss on some of their stakeholders, in our view. The question is not whether they will renege on their promises, but rather upon which of their promises they will renege, and what form this default will take."
- "So far during the Great Recession, sovereign (and bank) senior unsecured bond holders have been the only constituency fully protected from partaking in this loss."
- "It is overly optimistic to assume that this can continue forever. The conflict that opposes bond holders to other government stakeholders is more intense than ever, and their interests are no longer sufficiently well aligned with those of influential political constituencies."
- "There exists an alternative to outright default. ‘Financial oppression’ (imposing on creditors real rates of return that are either negative or artificially low) has been used repeatedly in history in similar circumstances."
- "Investors should be prepared to face financial oppression, a credible threat against which current yields provide little protection."

Morgan Stanley Sovereign Subjects 20100825

Investment Perspectives

- US Economics "Deleveraging the American Consumer: Faster than Expected"
- US Credit Strategy "Getting Some Credit"
- US Interest Rate Strategy "A New Leaf – Becoming More Tactical"
- Global Equity Strategy "The Rock, Part II – Don’t Ignore Yield"
- Europe Equity Strategy "Looking for Best Yield Opportunities"
- Equity Derivatives Strategy "Volatility Curves Help the Hunt for Yield"
- STEP Commentary "Behind the Spreadsheet: Adam Frisch"

Morgan Stanley Investment Perspectives 20100825

Strategy Forum

- "Markets are gripped by pessimism about a global slowdown and the risk of deflation. We think that pessimism is overdone, leading to our constructive view on risky assets. On today’s Strategy Forum we explore two aspects of that more constructive view."
- "First, we see cyclical and structural reasons why Asia will do well despite tepid developed-market growth. Chetan Ayha (Asia-Pacific economics) and Ridham Desai (India equity strategy) will discuss why they see the growth baton passing from China to India by 2013-15, highlighting the investment implications of that shift. Second, do you want to get paid for owning risky assets? Graham Secker (Europe equity strategy) offers a menu of stocks that exploit dividend yields exceeding bond yields. Rashique Rahman (EM macro strategy) outlines the case for EM debt, where yields are still high. And Hussein Allidina (commodities strategy) explores the allure of gold as a tailrisk hedge, based on low real rates."
- "As an aside, after meetings in Asia last week, I believe Asian investors are generally aligned with our views, especially on relative performance. Not surprisingly, they are upbeat on their region and on commodity prices. Big Asian investment funds are increasingly interested in EM
equities."

Morgan Stanley Strategy Forum 20100823

India and China: New Tigers of Asia, Part III

- "The huge surplus in the working-age populations in India and China has forced the world economy to recognize the countries’ roles in the global competitive dynamic. Both markets are increasingly integral to the business strategies of multinational companies and are viewed as structural drivers for global productivity. By 2020, we forecast India’s GDP will cross the US$6trn mark while China’s will surpass US$20trn, driven by the powerful combination of favorable demographics, structural reforms, and globalization. We expect the two economies to be the dominant growth stories for the next 20 years."
- "This report is the third part of our India and China: New Tigers of Asia series. Part I, published in July 2004, assessed the long-term outlook for the two economies during a period of rapid globalization. We highlighted how the rise of India and China is the most significant economic force in the world economy and that their growing presence will continue to change the rules that underpin the structure of global manufacturing and services output."
- "In Part II, published in June 2006, we focused on the challenges the two economies faced to maintain their growth trajectories beyond the then current boom. In that report, we highlighted that India had the potential to catch up to China’s economic growth rates over a 10-year period. Indeed, India is now not far from doing so."
- "In Part III, we focus on the long-term growth outlook in India. We believe that, over the next two years, India should start matching China’s economic growth, barring another global crisis, clearly reaping the rewards of very positive demographics and an increasingly dynamic economy."
- "We will continue to see both these economic powerhouses develop and reform as their respective models or stages of growth evolve as they create wealth and see their demographics change. The drive and dynamism both these economies provide to the world has and will become ever more important as they continue to develop and engage more intricately with the global economy."
- "This report provides some terrific insights into that evolution and the longer-term comparative factors driving the success of both economies. We now increasingly have a genuine double act from China and India in terms of dynamic economic growth engines willing and enthusiastic to engage with the global economy. This can only be beneficial for the continued growth and stability of the region and the world economy as a whole."

Morgan Stanley India and China New Tigers of Asia Part III 20100813

China Social Housing: Lackluster Growth or Quantum Jump?

- What's the Issue: "The social housing program has attracted a lot of attention from market observers of late. Many market observers had doubts about the progress being made so far and the prospect of fulfilling the social housing construction plan by the end of this year. At the same time, a dearth of timely and reliable data on this front makes it very difficult to evaluate and track the progress along the way."
- Our view: "We revisit and reaffirm our calls that: 1) the austere measures regarding property speculation will not cause a hard landing in fixed-asset investment growth in general and real estate investment growth in particular; and 2) the social housing program is on track and will constitute an important cushion for any potential slowdown in private market-based residential property construction and thus help ensure a soft landing in fixedasset investment growth. Moreover, we highlight a scenario featuring a potential “quantum jump” in construction of social housing in the latter part of the year that could tilt the balance of risks to the upside for fixed-asset investment growth. In this context, a potentially strong performance from a social housing program in 2010 would make the authorities’ pledge to “solve the housing problem for 15.4 million of low-income households by end of 2012” a lot more credible."
- Where we differ: "We take a hard look at the structure of real estate construction activity in China. By presenting our analysis in a flow chart format, we help clarify the relative importance of market-based private residential property construction vs. non-market-based residential property construction and, in that context, highlight the critical role of the social housing program in shaping the potential outlook for investment growth. We also compile a comprehensive set of data to help bridge an important information gap for monitoring the progress of the social housing program."

Morgan Stanley China Economics 20100813

China Interbank Liquidity Monitor

- PBoC withdrew liquidity last week: "After eight consecutive weeks’ (since late May) liquidity injection, totaling Rmb957bn, the PBoC drained Rmb101bn of net liquidity from the market last week (Exhibit 1)."
- Light redemption pressures explained the net withdrawal: "The PBoC issued Rmb125 bn of bills (Rmb45 bn of 1-year bills last Tuesday and Rmb80 bn of 3-month bills last Thursday), substantially below the issuance (Rmb240 bn) of the week before last. Much
lighter redemption pressure (Rmb39 bn last week vs. Rmb190 bn in the week before last) resulted in a net liquidity withdrawal of Rmb86 bn from bill issuance last week (Exhibit 3). Meanwhile, the PBoC sold Rmb50 bn of 91-day repo. Given Rmb35 bn of matured repo, the
PBoC drained a further Rmb15 bn of liquidity from repo operations. The reference yields of 3-month and 1-year PBoC bills remained unchanged at 1.57% and 2.093%, respectively (Exhibit 4). Largely bound by the reference yield of the 3-month bill rate, the 91-day repo rate stayed constant at 1.57% as well (Exhibit 6)."
- Further easing liquidity: "Interbank liquidity has continued to ease, with the 1-month SHIBOR sliding to 2.301% from the recent peak at 4.053% (Exhibit 2). This noticeable correction may have reflected the following factors: 1) liquidity injection by the PBoC; 2) completion of mid-year inspection on loan/deposit ratio; and 3) possible return of capital inflows."
- What’s next: "Given the relatively light redemption pressures, the scale of bill issuance and repo sales should be modest in the coming weeks (Exhibit 7). In light of the improved market liquidity situation, we expect the PBoC to continue with mild liquidity drainage in coming weeks to help stabilize the money market rates."
Morgan Stanley China Economics 20100726

Prepare for a period of value outperformance when stocks rally

- "Cheap valuations and washed out sentiment suggest a favourable risk-reward for European equities, as long as the global economy is not double-dipping. Our Combined Market Timing Indicator (CMTI) recently reached a buy signal of -0.5 for the first time since April 09. Following a CMTI reading of below -0.5, MSCI Europe has been up on average 9.2% over the subsequent 6 months, with equities up 85% of the time. At the same time sentiment is cautious with the AAII survey reaching its lowest level since March 2009 and 9 consecutive weeks of outflows from mutual funds. MSCI Europe trades on 10.3x 12 month forward earnings compared to a historical average of 14x since 1987. Given the structural headwinds to growth in this cycle 14x PE seems too high to us, however a return to historic averages of 11-12x in the 1970s-1980s would still suggest a further 10-20% upside from today’s levels."
- "Growth and quality factors have trounced value factors since September. From the March 09 lows through to September 09, cheap stocks outperformed expensive stocks by over 30%. In September we noted that the market was not providing sufficient reward to growth and quality factors. Our reliable growth basket traded at record low valuations to the market (see ‘Reliable Growth has never been cheaper’, 14th September 2009) and valuation dispersion became extremely narrow – all of which suggested a need to focus more on growth and quality in addition to valuation. However, since September there has been a significant style rotation away from value and towards growth strategies. High growth stocks have outperformed low growth stocks by over 8% since September, while value stocks have underperformed by 12%. 27 of the top 40 stock picking strategies since September have been related to either growth or quality. This style rotation has become even more pronounced since the market peaked in April as the market has become even more focussed on concerns over global growth."
- "Reliable growth stocks should be long-term winners, but given strong outperformance we would prefer the cheaper end of the reliable growth universe in the next 3-6M. Our reliable growth basket has outperformed steadily over the last nine months and no longer trades at a discount to the market. Structurally these stocks should be long-term outperformers against a backdrop of anaemic GDP in the West. However, given we believe stocks are more likely to go up than down by year end, we would look to rotate toward the cheaper constituents (see ‘Updating our thoughts on reliable growth’, 5th July 2010 for more details)."
- "We would also rotate back into some value screens given the potential for a strong rally in the next 6M. MSCI Europe Growth now trades at an above average premium to MSCI Europe Value. The outperformance of the MSCI Europe Growth index vs the equivalent Value index over the last nine months is high by historic standards – in fact the only occasion where such outperformance was significantly higher than now was 1999/2000. Valuation dispersion has also widened by 1 standard deviation in the last few months. We believe that as and when equities move higher, the market’s focus on quality and defensive growth will become less binary. As such we feel that it is an appropriate moment to screen for stocks that are either oversold or offer exceptional value."
Morgan Stanley European Strategy 20100712

Strategy Forum

- "Our basic call is more constructive than the consensus on the global outlook, and it hinges on three factors that we address today: prospects for the US economy, European banks, and China."
- "Looking at the US economy, David Greenlaw explains why he is not in the double-dip camp."
- "Then Huw van Steenis from our European banks team comments on the forthcoming stress tests."
- "And finally, our EM equity strategist Jonathan Garner explores his outlook for the Chinese economy and EM equity markets."
Morgan Stanley Strategy Forum 20100706

Contagion, Exposure and the Policy Response

- Bottom line: "Developments in the periphery can affect the rest of the euro area through various channels, ranging from the bond market to exports, confidence and bank lending. Contagion risks can be considerable in some cases, especially when countries the size of
Spain and beyond enter the picture. We look at the theme of contagion from four different angles:"
1. Exposure to the peripheral bond markets – who owns what? "Euro area banks’ exposure to the EMU periphery could amount to about €140 billion. Germany’s banking sector seems most exposed to Spain, France’s to Greece and Spain’s to Portugal."
2. Exports to the EMU periphery – is there a material risk? "No, not really. But German and, to a lesser degree, Italian exports are likely to be less affected by poor
economic prospects at the periphery than France’s and Spain’s, given their geographical specialisation."
3. How about the ‘confidence factor’? "The mood in core EMU is more upbeat than in the periphery, where it has not yet reached its long-term average. Negative feedback effects, admittedly unquantifiable, are more likely in the latter group of countries than in the former."
4. What’s the impact of an impaired bank lending channel? "Potentially large, we think. The chances are that the robust credit expansion witnessed over the past decade will not be there to support the euro area economy as and when growth strengthens."
- The policy response: "Providing additional liquidity can only buy time. Given the size of the fiscal and banking sector problems, a quick solution is unlikely. But we think that the recapitalisation of the banking system, along with further fiscal restraint and structural reforms in many EMU peripheral and also some core countries, might help to address the underlying issues."
Morgan Stanley Euroland Economics 20100702

No Relief from the ‘Trilemma’

- "The PBoC surprised markets at the weekend by removing the currency peg to the US dollar. Not surprisingly, the lack of explicit detail in the PBoC’s communication left investors divided about how significant the appreciation is likely to be."
- "Our China economics team’s prescient call on a summer de-pegging before the G20 summit was for a modest appreciation this year and a continuation of the appreciation into 2011."
- "If this change in policy is a precursor to a more flexible exchange rate regime, then it is a welcome first step away from political frictions and towards a more balanced domestic economy in China, and a more balanced global economy as well."
- "In the short run, however, the predictability of the appreciation may actually increase the constraints on policymakers, in our view. The move to a more flexible exchange rate should, in theory, provide more independence to monetary policymakers."
- "However, the predictable nature of the current regime means that any policy tightening could exacerbate capital inflows and lead to even greater accumulation of reserves."
Morgan Stanley Global Monetary Analyst 20100623