Investing Without Borders Report - Electronic - 20140807c

investment strategy august 2014
4 10 Reasons to Go International 31 The Major Risks

15 Outlook for Major International Asset Classes 33 Implementation
23 Outlook for Major International Regions
Special Report
Investing Without Borders:

A Primer on International Investing
RESEARCH PORTFOLIO STRATEGY & RESEARCH GROUP AUGUST 4, 2014
Special Report
AUSTRALIA Investing Without Borders: A Primer on
MALCOLM WOOD International Investing
Morgan Stanley Wealth Management Research
x Australia is rapidly globalising across multiple dimensions,
SZE CHUAH including travel patterns, consumption habits and business
Morgan Stanley Wealth Management Research investment. Surprisingly, however, international investing lags far
behind, with just 3% of household assets invested offshore. This
EWA TUREK special report demystifies international investing, and provides a
Morgan Stanley Wealth Management Research manageable strategy to increase international exposures.
TERRY J. YUAN, CFA x In Part I, we present 10 reasons to increase international
Morgan Stanley Wealth Management Research investment. Australias strong economic outperformance has
probably peaked, and with it the currency. International investing
offers diversification benefits on both geographic and industry
levels, as well as exposure to emerging and high growth
opportunities. We also highlight that International Investing
should be an important consideration in effective asset allocation.
x In Part II, we provide an overview of the major international asset
classes, equities, fixed income (including credit), listed property
and alternatives. We spell-out the reasoning behind our medium-
term expected returns for each asset class.
x In Part III, we provide our outlook for the major regions,
including the US, Europe, Japan and Emerging Markets.
x In Part IV, we analyse the key risks to consider in international
investing and ways to manage those risks.
x In Part V, we provide an overview of ways to gain international
investment exposures, be it direct investments, Exchange Traded
Funds, Listed Investment Companies, and/or Managed Funds.
This report is for distribution only to Australian resident clients of Morgan Stanley.
Morgan Stanley Wealth Management does and seeks to do business with companies covered in Morgan Stanley Wealth Management
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
Wealth Management Research. Investors should consider Morgan Stanley Wealth Management Research as only a single factor in making
their investment decision.
RESEARCH SPECIAL REPORT AUGUST 4, 2014
Table of Contents
Preface.................................................................................................................................................3
Part 1: 10 Reasons to Go International ..........................................................................................4
International Investing in an Asset Allocation Context ..................................................................................................... 14
Part 2: Outlook for the Major International Asset Classes ......................................................15

International Equities............................................................................................................................................................. 15
International Listed Property ................................................................................................................................................ 17
International Fixed Income ................................................................................................................................................... 18
Alternative Assets .................................................................................................................................................................. 21
Part 3: Outlook for the Major International Regions.................................................................23

The United States .................................................................................................................................................................. 23
Euro Area and United Kingdom ........................................................................................................................................... 25
Japan ....................................................................................................................................................................................... 27
Emerging Markets.................................................................................................................................................................. 29
Part 4: The Major Risks..................................................................................................................31

Part 5: Implementation...................................................................................................................33
International Equities............................................................................................................................................................. 34
Listed Property ....................................................................................................................................................................... 37
Fixed Income .......................................................................................................................................................................... 37
Alternative Assets .................................................................................................................................................................. 38
Please refer to important information, disclosures and qualifications at the end of this material. 2
Preface
Australia is rapidly globalising across multiple dimensions. 8.7 We see 10 reasons why investors should increase their
million Australians, or more than one-in-three, travelled international exposures:
overseas in 2013. International travel has surged at an 8.6%
1. Australias Dramatic Outperformance Has Peaked: over
compound annual growth rate (CAGR) over the past decade,
the current 23-year record expansion, Australia has
reflecting the strong Australian Dollar, rapid income growth and
outgrown its Advanced Economy peers by an average
a strong outward focus (Figure 1).
1.22% p.a. We question whether this can continue.
Figure 1: Australian International Travel has Surged Over
2. Deteriorating Australian Dollar Fundamentals:
the Past Decade
Declining commodity prices and narrowing relative interest
rates point to ~10% downside on the Australian Dollar.
3. Elevated Australian Purchasing Power: comparing
inflation in Australia and the US over the long-term,
Purchasing Power Parity is ~70 cents, 25% below current
levels. Investors should take advantage of this opportunity.
4. Australia is Just 2% of the World: Australia represents
just 0.3-3.2% of the world under various estimates.
Focusing on Australia means investors largely ignore the
opportunities offered in the remaining 96.8-99.7%.
5. Yet A Surprisingly Low Starting Point: only c.3% of
Australian household assets are offshore. However, with
Source: ABS, MSWM Research superannuation assets likely to quadruple to ~$7.6 trillion
Australians are also globalising their consumption habits, with by 2033, this is likely to rise significantly.
consumer goods imports growing at a strong 6.6% CAGR over 6. The Benefits of Diversification: When combined with
the past decade to about 30% of consumer goods spending. other asset classes, international assets can reduce overall
There has been an increasing preference for international portfolio risk by offering exposure to different economic
brands. For example, imports have risen from 68.5% to 89.0% cycles, regions, industries and technologies.
of domestic vehicle sales over the past decade (Figure 2).
7. Exposure to New Growth Opportunities by Geography:
Figure 2: The Market Share of Locally-Made Vehicles has Emerging and Frontier Markets are growing much faster
Fallen From 31.5% to 11.0% Over the Past Decade than Developed Economies, and now represent a substantial
46% of world GDP in current dollar terms.
8. Exposure to New Growth Opportunities by Product:
Despite some local success, the vast majority of emerging
technologies originate offshore.
9. Australia is Rapidly Globalising: Reforms in the 1980s
and 1990s have seen trade and investment barriers decline
significantly. However, Australian asset allocation is yet to
globalise, lagging its peers and other industries.
10. Longer-Term Returns: Rarely does one asset class
consistently outperform. However, over the past 10-15
years Australian equities have outperformed International
equities. We see this as unlikely to recur.
Source: ABS, MSWM Research To round out our proposition, we also provide:
Australian business is also globalising, with many businesses x An outlook for the major international asset classes;
generating far more than 50% of revenues and operating profit
x An overview of the key international markets- the US,
from international operations. Australian direct foreign
Europe, Japan and Emerging markets- and their prospects;
investment now exceeds foreign investment in Australia.
By contrast, Australians are undeveloped international investors. x A perspective on the major risks in international
Morgan Stanley estimates that on a look-through basis, investing; and
Australian households have only about 3% of their assets x An analysis of the key ways to implement this theme.
invested internationally.
Part 1: 10 Reasons to Go International Figure 4: Australia GDP Growth has Dramatically

Outperformed Other Advanced Economies
1. Australias Dramatic Outperformance Has
Peaked
Australia has enjoyed an unparalleled period of economic
success in both absolute and relative terms since the early
1990s. In a record-breaking 23-year economic expansion, Real
Gross Domestic Product (GDP) has grown at a 3.4%
compound rate, almost quadrupling nominal GDP from $415
billion in 1990-91 to $1573 billion currently (Figure 3).
Figure 3: Australian Real GDP: A 23-Year Expansion
Averaging a Robust 3.4% p.a Growth
Source: ABS, IMF, MSWM Research
What has driven Australias dramatic outperformance, and can it

continue? We attribute the outperformance to five key factors:
i. Relatively strong demographics. Australias population
growth at 1.6% p.a. over the past decade, significantly
augmented by migration, far outstrips the Advanced
Economy average. This advantage should persist, though
migration is likely to slow down if economic performance
deteriorates.
ii. A strong reform track-record in the 1980s and 1990s,
with financial and industrial deregulation, privatisation, tax
Source: ABS, MSWM Research reform and industrial relations reform. With reform in
In per capita terms, the trends are equally impressive. Real Australia losing momentum over the past decade, whilst
GDP per capita has risen at a 2.0% rate, lifting GDP per capita other countries have been forced to reform by the GFC, this
by 180% over the same period from $24,140 to $67,570. is no longer an advantage.
Household income in nominal terms has increased at a 6.0%
rate, lifting aggregate income from $367 billion to $1352 iii. Strong policy performance, led by the Reserve Bank and
billion! On a per household basis, average gross income is a Australian Prudential Regulation Authority (APRA).
strong $150,410, while disposable income is $116,530. Australia has an established track-record of low inflation
and prudential regulation. However, Australias strong
While absolute performance has been very impressive, relative relative fiscal performance has deteriorated in the past few
performance has been equally compelling. In all but three of years. A key task for the new Government is to restore this
the past twenty-three years (87% of the time), Australia has performance, yet a fragmented Senate may make this
outgrown its Advanced Economy peers (Figure 4). Indeed, difficult.
Australias Real GDP growth has averaged 1.22% p.a more than
its peers, representing a cumulative 32% outperformance in real iv. An unprecedented rise in Australias terms of trade,
terms over twenty-three years. By contrast, between 1980 and which is now partly reversing, and appears highly unlikely
1991 Australia performed in-line with its Advanced Economy to recur given substantial investment lifting commodity
peers, outperforming in 50% of years. supply growth.
In US Dollar terms, Australias performance has been even v. The strong performance of Australias Major Trading
more impressive, reflecting the appreciation of the Australian Partners, an outperformance we expect to continue, though
Dollar from the high-70s to the low-90 cents currently. Indeed, the gap is likely to narrow.
Australias share of world GDP has risen dramatically, from a Overall, Australias strong absolute and relative economic
low of 1.2% in 2001 to about 2.0% in 2013 (Figure 12). This is performance has probably peaked, and appears likely to narrow
particularly impressive for a country of 23.5 million people, or moving ahead. Moreover, the likelihood of Australia avoiding a
just 0.3% of world population. recession over the next decade- for a third consecutive decade-
seems low.
2. Deteriorating AUD Fundamentals allocation who would have lost 55.4%. This relatively positive
outcome primarily reflects the way in which the Australian
The Australian Dollar is well above its fundamental level. The
Dollar behaves in a risk-off environment. While the AUD fell
key short-term fundamental drivers of the currency are
24.7% against the USD, cyclical Australian equities fell sharply,
commodity prices as a proxy for the terms of trade (export
and the USD appreciated 7.4% against a basket of currencies.
prices divided by import prices) and relative interest rates.
Both of these indicators have been deteriorating since 2011, Figure 5: RBAs Commodity Index Down ~37% vs Peak
pointing to downside to the Australian Dollars fair-value.
The Reserve Banks non-rural commodity index in US Dollar
terms has fallen ~37% from its 2011 peak, and is back at levels
seen in 2008-09. Nonetheless, it remains very high by historic
standards, being about three-and-a-half times the levels of 10-15
years ago (Figure 5). Over the long-term, despite rising supply,
the consensus foresees commodity prices ~19% higher.
Similarly, since late-2011 the Reserve Bank has cut official
interest rates from 4.75% to a record low 2.50%. This has
lowered the entire Australian yield curve, pushing Australia-US
interest rate spreads to around average levels- the average 2- and
10-year spreads over the low inflation period have been 200bps
and 120bps respectively (Figure 6). But with super-
accommodative monetary policies in most major Developed Source: Bloomberg, RBA, MSWM Research
economies since the GFC, as reflected in zero official interest Figure 6: Australia-US Interest Rate Spreads Narrowing
rates and Quantitative Easing, the decline in rate spreads so far
has come from the Australian side.
Looking ahead, as the global economy continues its post-GFC
healing process, we expect a gradual return to normal policy
rates in the major Developed economies, led by the US and UK.
This is particularly important because global investors own a
near-record high two-thirds of the Australian bond market. As
the global economy recovers and spreads narrow, the impetus
for holding such a high weighting in Australian bonds should
dissipate. Moreover, as interest rate spreads continue to narrow,
this should push the currencys fundamentals lower.
The MSWM Research Currency model, which uses commodity
prices and interest rate spreads, currently predicts a spot
exchange rate of 85c. When forward estimates for commodity Source: Bloomberg, MSWM Research
prices and relative rates are considered, the AUD could fall into
Figure 7: The AUD Serves as a Natural Hedge During
the low-80s.
Major Global Market Drawdowns
The AUD Also Serves as a Natural Hedge
While our base case is that the Australian dollar is currently
~10% overvalued and is likely to depreciate going forward,
another benefit for Australian investors who diversify into
international assets is the currencys role as a natural hedge. As
a natural hedge, during major tail-risk events (such as the GFC)
the Australian dollar tends to sell off (given its status as a high-
risk currency). Conversely, the US Dollar tends to appreciate,
given its status as a safe-haven currency.
The implication of this is that an Australian investors loss on an
international equity exposure is moderated by a decline in the
AUD. This is illustrated in Figure 7. Over the course of the
GFC (July 2007 February 2009) an Australian investor would
have lost 35.4% on their international exposure, compared to a Source: Bloomberg, MSWM Research. Returns between July 2007 and
loss of 45.0% on Australian equities. This outcome is even February 2009.
better than for a US-based investor with an international equity
3. Elevated Australian Dollar Purchasing Figure 8: Australian Dollar Purchasing Power Parity ~70c
Power
The Australian Dollar is at elevated levels on almost any metric,
offering unusual purchasing power for Australian investors. A
long-term measure of value is Purchasing Power Parity (PPP).
Comparing inflation in Australia and the US over the long-term
(using CPI indices) would suggest that PPP is currently around
70 cents (Figure 8). Since the float of the Australian Dollar in
late-1983, the AUD/USD has averaged 76 cents, but Australias
CPI has risen 3.6% p.a versus 2.8% p.a for the US. Since the
low inflation period began in Australia in the early 1990s, the
AUD/USD has averaged 76 cents, whilst Australian prices have
risen at a 2.6% rate versus 2.4% for the US.
More recently, while Australian inflation has been moderate,
Source: ABS, Bloomberg, MSWM Research
inflation in the US has been extremely low and the Euro-Area
has verged on deflation. Combined with the elevated Australian Figure 9: Australian Trade Balance The Resources Export
Dollar this has rendered many parts of Australian economy Boom Driver has been Disrupted by Lower Bulk Prices
uncompetitive, as reflected in widespread closures of
manufacturing capacity.
Two long-term positive trends for the Australian Dollar have
been the Resources Boom and the rise of Asia. As noted above,
however, Australian commodity prices have fallen ~37% from
peak levels. Furthermore, the Resources Investment Boom has
also peaked, and stands on the verge of a cap-ex cliff.
Nonetheless, this investment is transitioning into an export
boom, with iron ore and LNG export volumes at current prices
expected to lift exports by ~US$85 billion or ~6% of GDP over
2012-18, while imports of resources-related capital goods
imports should decline by ~2.5% of GDP. That said, lower
commodity prices, particularly for iron ore and coal, are
currently disrupting this trade improvement (Figure 9).
Source: ABS, MSWM Research
Australia is often seen as a currency proxy for Asia- see Figure
Figure 10: Australian Dollar may be starting to wane as an
10- reflecting its significant trade exposure to Asia and its
Asian-Proxy Currency
freely-floating currency. A record 77% of Australias exports
are now sent to Asia, including 37% to China, 18% to Japan and
7.5% to Korea. This is up from ~55% a decade ago. By
contrast, just 4.5% and 3.5% of exports go to the EU and US
respectively. While a positive whilst Asia is growing strongly,
this would represent a major headwind should Asia experience a
downturn similar to the Asian crisis of 1997-98.
Australias free-float, with almost no intervention from the
Reserve Bank, stands in sharp contrast to the managed exchange
rate regimes of most of Asia. However, as China continues
financial deregulation, easing exchange controls and currency
intervention, the need for a proxy should wane. This is not an
immediate threat, but should emerge over the next three-to-five
years.
In conclusion, the Australian Dollar at ~35% above Purchasing Source: Bloomberg, MSWM Research
Power Parity offers Australian investors an unusual opportunity
to invest internationally. Two long-term factors that have
helped elevate the AUD- the Resources Boom and an Asian
currency proxy- have also peaked. Short-term drivers of the
currency - commodity prices and relative interest rates are also
deteriorating- for details see point 2.
4. Australia is Just 2% of the World on a average, primarily a reflection of the elevated exchange rate, but
also of the relative decline of Japan and, to a lesser extent, the
Good Day Euro-Area (Figure 13). Indeed, Australia ranks 8th, behind the
Australias population, on the back of rapid 1.6% p.a growth G5 economies, Canada and Switzerland (Figure 14). With
during the Resources Boom, has grown beyond 23 million Australias relatively small Government bond market, its share
(Figure 11). Even so, with global population exceeding 7 billion of world fixed income markets is quite low.
people, Australias share of world population is just 0.32%.
Figure 13: Australias Share of the MSCI World Index is an
Figure 11: Australias Robust Recent Population Growth Elevated 3.2%

Source: Factset, MSWM Research. Data as of 26 June 2014.
In GDP-terms, Australia as an Advanced Economy has a much
higher share of world GDP. Using the IMFs estimates of Figure 14: Australia Ranks 8th in MSCI World Markets
Purchasing Power Parity as the basis for comparing GDP,
Australia is about 1.2% of PPP-world GDP. Despite
Australias strong growth for much of the past 20 years, the far
stronger growth of Emerging Markets has meant that Australias
share of World GDP in PPP-terms has declined from about 1.3%
30 years ago (Figure 12).
However, using current exchange rates as the basis for
comparing GDP, the elevated Australian Dollar, trading well
above Purchasing Power Parity, pushes Australias share of
world GDP to a multi-decade high of 2.0% of current dollar
world GDP, up from a low of 1.2% in 2001 (Figure 12).
Figure 12: Australias Share of World GDP has Risen
Dramatically, Helped by the Strong AUD, to 2.0%

Australia is boxing well above its weight, whether it be in terms
of share of PPP-world GDP, current dollar world GDP or world
equity market capitalisation. As noted above, such dramatic
outperformance is becoming more difficult to sustain.
Furthermore, Australian investors with a strong home-bias focus
on anywhere from 0.3% to, at most, 3.2% of the world. As such,
they are effectively ignoring the opportunities offered by the
remaining 96.8-99.7% of the world!
Source: ABS, IMF, MSWM Research
Turning to financial markets, Australia has a 3.2% weight in

the MSCI World index. This is well above its 2.1% long-term
5. A Surprisingly Low Starting Point view this rise exaggerates the importance of international assets
for two key reasons.
The introduction of compulsory superannuation and the Super
Guarantee Levy has driven a surge in long-term retirement Figure 17: Australian Super Fund Exposure to Overseas
assets by Australian Households. Indeed, since mid-1988 super Assets has Crept up to 17.8%
assets have risen from $95 billion to $1.78 trillion, a 12.1%
CAGR (Figure 15). As a share of GDP, superannuation assets
have increased from 28% in the late-1980s to 111% of GDP
currently, and as a share of disposable income from 42.5% to
167%. Looking forward, Deloitte projects that the system will
grow to $7.6 trillion by 2033, or approximately 180% of GDP, a
growth rate of 7.6% p.a (Figure 16).
Figure 15: Australia Superannuation Assets ($bn) - Rapid
Growth
Source: RBA, MSWM Research
First, superannuation has been taking a growing share of

household financial assets. Reflecting the compulsory nature
and tax advantages accruing to super, over the same period
super has grown from 43.5% of household financial assets to
57.3%.
Second, this analysis excludes all other household assets. To
gain a total perspective of the asset allocation of all household
Source: ABS, RBA, MSWM Research assets requires looking-through the asset allocations of
superannuation funds and life offices, and adding that to
Figure 16: Australian Super Assets Have Outgrown directly-held household direct and financial assets. On this
Domestic GDP and are Set to Rise to $7.6tr or 180% of GDP basis, just over 3% of assets are in foreign equities, versus 54%
in 2033 in housing, and 12% in domestic equities and 12% in cash
(Figure 18). Put another way, Australians allocate 97% of their
investments to just 2% of the world economy.
Figure 18: Australian Household Exposure to Global
Equities is Just 3% of Total Assets
Source: Australian National Accounts, 2012, Deloitte Analysis 2013
Within super, the major asset allocation shift over the past 25
years has been to reduce fixed income and to increase equities,
both domestic and international. Some of this shift reflected
financial deregulation, with the abolition of exchange controls
and the 30:20 Rule in the 1980s. Domestic equities have Source: ABS, MS Research. Share of household assets
increased by ~20ppts to about a 50% allocation. Overseas assets
(predominately equities) have increased a more moderate ~5-
10ppts, rising from less than 10% of assets in the late 80s to a
high-teens exposure currently (Figure 17). However, in our
6. The Benefits of Diversification particularly bulk materials, LNG, and base and precious metals.
By contrast, the Australian market is very underweight the
A key benefit of building a portfolio of assets and securities is
Information Technology, Healthcare, Industrials and Consumer
diversification. Diversification adds value to a portfolio because
Discretionary sectors (see again Figure 20). These significant
in combining asset classes it is possible to eliminate a certain
differences mean that a portfolio focused on the Australian
amount of risk through the inherent relationships (correlations)
market will not get material exposure to the following
between different asset classes. For example, if an investor held
industries:
a stock and a bond, and the value of the bond rose 1% for each
1% fall in the stock, the risk of the combined holdings would be x Technology- software, technology hardware and
reduced. Indeed, any movement in the stock would be equipment, semiconductors and semiconductor equipment;
countered by a similar offsetting movement in the bond. Despite
this very simple example, relationships similar to this can reduce x Healthcare- pharmaceuticals, biotechnology and medical
risk within a portfolio. products;
International securities offer diversification by geography and x Industrials- machinery, aerospace, commercial services;
industry (Figures 19 and 20). At a geographic level, Australia, x Consumer Discretionary- autos and consumer services;
as noted above, is barely 2% of the global economy and 3% of
global equity markets (Figures 12 and 13), so by definition x Consumer Staples- household and personal products, food,
international investing provides access to the remaining 97% of beverages and tobacco.
global equity markets.
x Energy- oil services, refining and integrated energy
While Developed Markets (DM) are somewhat structurally companies;
similar to Australia, as high-income, mixed economies with
sophisticated services and technology industries, most are at x Materials- paper and chemicals.
very different stages of the business cycle to Australia. The Figure 20: Australian Equity Sector Weights are
Global Financial Crisis left most DM, particularly the US and Concentrated in Materials and Financials, and Weak in
Euro-Area, with high unemployment, large output gaps, little Technology and Health Care
inflationary pressures and zero official interest rates. The
reform process catalysed by the crisis could provide
opportunities for strong growth once the deleveraging reaction
to the GFC runs its course.
Figure 19: MSCI World Weights by Region
Source: Factset, MSWM Research. Weights as of July 2014.
A strong argument in favour of international exposure is the

benefits of diversification by geography, phases of the business
cycle, stages of economic development and industry exposure.
In addition, international investment offers exposure to

Emerging and Frontier markets. Whilst the recent phase of EM
growth has played to Australias strengths in mining and energy
production, the next phase could well benefit consumer-related
sectors.
At an industry level, the Australian market is heavily exposed to
the Financials and Materials sectors (Figure 20). This reflects
industry policy- Australias four pillars banking sector policy-
and Australias comparative advantage in the resources sectors-
7. Exposure to New Growth Opportunities- Figure 22: Emerging Markets Are Trading at a Hefty ~33%
Discount to the US Market
By Geography
Given Australia is ~2% of the global economy, it should be no
surprise that new growth opportunities typically emerge
internationally, whether it be by geography or industry. At a
geographic level, most high growth opportunities exist in
Emerging Markets (EM). Since the collapse of the Berlin Wall
in 1989, EM have grown at a 5.1% annual rate, more than
double the 2.2% of the Developed Markets (DM). Since 2000,
effectively excluding the post-Communism adjustment in the
Eastern Bloc and the Emerging market crises of the mid-to-late-
1990s, the gap is much wider, with EM growth averaging 6.1%
versus 1.8% in the DM. As a consequence of this sustained
outperformance, EM are rapidly closing the growth gap with
DM. Indeed, in PPP-terms, EM surpassed DM in 2007, and are
now 57% of the global economy (Figure 21). Even using Source: Factset, MSWM Research
current GDP, EM are 46% of world GDP, up from 27% a This can also be illustrated at a sector level in Figures 23 and 24.
decade ago. Using IMF forecasts, EM should rise to 61% of For example, Figure 23 shows that the majority of sectors in the
world GDP by 2019 on a PPP-basis, and almost half on a current China market tend to trade on lower forward PE multiples than
dollar basis. in most other regions, yet Figure 24 shows that these sectors in
Figure 21: Emerging Economies Surpassed Developed China tend to offer some of the best forecast earnings growth!
Economies in 2007 in PPP-Terms- They are Now 57% Obviously one has to take into account various factors, such as
policy, regulatory conditions and gearing levels, but broadly
speaking this could mean that some markets are being mispriced
creating investment opportunities. For example, the Financials
sector in Australia is one of the most expensive globally
reflecting the well capitalised nature of its banks - yet offers just
6-7% EPS growth. On the other hand, in Europe, Financials
trade on just 11x, reflecting recessionary risks, yet consensus is
forecasting 18% earnings growth. If one has confidence in the
earnings outlook, Financials in Europe appear cheap.
Figure 23: PE - Companies in China on Lower Multiples
Source: IMF, MSWM Research
Looking ahead, Morgan Stanley expects EM growth to

comfortably lead DM, with EM growing at a 5.3% rate over
2015-18, whilst the G10 should grow at a 2.0% CAGR. Using
these forecasts, moderately higher inflation and a moderate pace
of currency re-rating should lead EM to surpass DM in absolute
terms in 2016.
By contrast to its increasingly important share of world Figure 24: EPS Growth - China Offers Higher Growth
economic activity, however measured, EM are still a small part
of global financial markets, at just 10.8% of the MSCI All
Country World index. This partly reflects a large valuation
discount being applied to EM, with the current discount to the
US market a substantial 33% (Figure 22). In turn, this partly
reflects fears of the impact of the end of US Quantitative Easing
and Fed tightening, as well as on-going fears about China and
imbalances in the Fragile Five EM economies (Brazil, India,
Indonesia, Turkey and South Africa).
Source: IBES, MSCI, MSWM Research. Green indicates higher growth or
higher PE. Yellow indicates lower growth or lower PE for the sector.
8. Exposure to New Growth Opportunities- Foxconn and Samsung, and electronic screen manufacturer
Corning.
By Industry
At an industry level, some of the new growth opportunities over Figure 26: Percent of Chinese Accessing Internet via Mobile
the past decade outside Australia include: Now Exceeds the Desktop
x Social media allows individuals to quickly communicate,

organise, publish and share content with their immediate
personal circle or the world. Some of the most prominent
sites include the ubiquitous Facebook, professional services
network LinkedIn, short content publishing platforms Sina
Weibo and Twitter, short messaging services WeChat
(owned by Tencent) and WhatsApp (owned by Facebook),
online restaurant user review site Yelp, and online video
streaming site YouTube (owned by Google).
x Green Tech technology used to conserve or promote the
environment, including sustainable energy generation. One
prominent example is the electric sports car maker Tesla.
x Internet Search internet search engines are in a strong Source: China Internet Network Information Center
position to monetise internet traffic by selling customised
advertising to users. Some of the largest sites are Chinese x Biotech and pharmaceuticals involves the engineering
site Baidu, Google and Yahoo!. Internet advertising of living organisms and chemicals for commercial and
revenue surpassed broadcast TV revenues in the US last therapeutic purposes. Some of the largest biotech
year (Figure 25). companies are disease and cancer treatment manufactures
Amgen, Biogen Idec, and Celgene Corp.
Figure 25: Internet Advertising in the US Surpassed
Broadcast TV in 2013 (US$bn) x Sharing Economy one of the most recent innovations in
technology is something known as collaborative
consumption (the sharing or peer economy). Owners of a
particular asset such as a car, house or bicycle rent these out
to others using an online peer-to-peer service. Key players
in this space include Airbnb, Uber, TaskRabbit and Lyft.
While many of these companies are still private, Airbnb, a
San Francisco startup and a premier company in the online
accommodation rental space, is expected to launch an IPO
in late-2014.
The point of this long list of new and emerging technologies is
to highlight that they almost always appear in international
markets, particularly the US. While Australia has undoubtedly
developed successful new products- Cochlear, Resmed, Seek,
Source: Interactive Advertising Bureau etc. - the vast majority of new products have emerged in
international markets.
x E-commerce By providing a 24 hour global platform to
bring buyers and sellers together, the internet has increased
shopping convenience, speed, and access to the best
pricing. Some of the largest players are Amazon, Ebay, and
daily bargains mailing list distributer Groupon. More
recently this trend has extended to online retailing via
companies such as UK based ASOS.
x Mobile devices The PC age has moved to the tablet and
mobile age. Chinese internet users accessing via mobile
phones exceeded those accessing via a desktop in 2012, and
at the end of 2013 exceeded desktops by healthy margin
(Figure 26). Stocks that have become market leaders in this
space are computer chip manufacturers AMD, Intel, and
Qualcomm, tablet and mobile manufacturers Apple,
9. Australia is Rapidly Globalising This has been part of a broader globalisation of the Australian
economy. The reforms of the 1980s and 1990s reduced
Perhaps reflecting Australias small population, small share of
protection, deregulated industry and the financial sector, and
world GDP and close familial and historic links to the rest-of-
privatised Government-owned businesses. More recently, the
the-world, Australians tend to be very outward looking. This
government has concluded free-trade agreements with Japan and
trend has been particularly apparent over the past two to three
Korea, continuing the steps begun with free-trade agreements
decades, and has rapidly accelerated in the past decade. This is
with the US, Singapore and Thailand from a decade ago.
reflected in travel patterns, consumption habits, trade and
international capital flows. Figure 29: Australian Exports and Imports- A Dramatic
Rise as a Share of GDP
In 2013, for example, 8.7 million Australians travelled
internationally, or almost 40% of the population (Figure 27).
Just thirty years ago, less than 10% of Australians travelled
overseas in any one year. Over the past decade, departures have
more than doubled, rising at an 8.6% CAGR.
Figure 27: Dramatic Increase in International Travel by
Australians
The floating of the exchange rate and the abolition of exchange

controls in Dec-1983 accelerated the globalisation of Australian
capital flows. For example, since the late 1980s, Australian
Equity Portfolio Investment overseas has risen over 30 times to
A$363.5 billion, whilst Foreign Equity Portfolio Investment into
Source: ABS, IMF, MSWM Research Australia has risen by a factor of 20 times to A$419.2 billion
(Figure 30). Portfolio Investment into Debt securities and Direct
Similarly, Australian consumers have dramatically increased Investment have also boomed, increasing Australian ownership
their imports of consumer goods. Over the past decade, of overseas businesses, and foreign ownership of the Australian
consumer goods imports have almost doubled, rising at a 6.6% economy.
annual rate to reach A$79.4 billion in 2013 (Figure 28). Over the
past three decades, nominal consumer imports have risen 15.6 Figure 30: Australia Equity Portfolio Investment Abroad
times (or at a 9.6% rate)! As a share of GDP, consumer goods and into Australia
imports have risen from 2.56% of nominal GDP to 5.11%.
Figure 28: Surging Australian Consumer Goods Imports
Source: ABS, RBA, MSWM Research
In our view, this multi-faceted trend toward globalisation should

Source: ABS, MSWM Research. also extend to the way in which Australian households allocate
their wealth.
10. Long-Term Returns - Rarely Does One largest terms of trade boom in Australias history. Third, the
Global Financial Crisis of 2008-09 and the subsequent Euro-
Asset Class Consistently Outperform Area Sovereign debt crisis of 2010-12, events from which
A cursory analysis across the major asset classes shows that the Australia emerged largely unscathed. These events seem
best performing asset is rarely the same from year to year (see unlikely to recur, at least for the foreseeable future.
Figure 96 in Appendix). It can also be seen that over the long-
term the best performing asset classes have been Equities, both Figure 33: Two Features of the Past 15 years - US Equity
Domestic and International. That said, there have been phases De-rating and the Australian Dollar Re-rating
where International Equities have outperformed Domestic
Equities, and vice versa. In the 1980s and 1990s, for example,
International Equities outperformed Domestic, assisted by
currency weakness and the US TMT-equity boom (Figure 31).
In the 2000s, by contrast, Domestic Equities outperformed,
assisted by the Resources boom and currency strength (Figure
32).
Figure 31: International Equities Strongly Outperformed
Australian Equities in the Late-1990s
Source: Factset, RBA, MSWM Research
Looking forward, we contend that Australias period of

significant outperformance is drawing to a close. Since 1991,
Australia has enjoyed 23 years of uninterrupted growth,
outperforming other Advanced Economies in 87% of years and
by an average 1.22% p.a. Back in the 1980s, however,
Australia grew in-line with its peers, outperforming in just 50%
of years. In particular, we expect Australian growth to lag US
growth over the next few years, ending a period of
outperformance that began in 2000 (Figure 34).
Source: Factset, MSWM Research
Figure 34: Australia Has Consistently Outgrown the US
Figure 32: But from January 2001 Australian Equities Every Year Since 2000 - We See This Ending in 2014-15
Enjoyed Almost a Decade of Relative Outperformance
Source: IMF, ABS, MSWM Research
In the next section, where we analyse the prospects for future

Source: Factset, MSWM Research
returns for different asset classes, we will endeavor to show that
In our view, the past 10-15 years have exhibited three unusual international assets not only offer the benefits of diversification,
features, all of which have adversely impacted International but also very competitive prospective returns to domestic assets.
Equity returns in Australian Dollars. First, the bursting of the
US equity market bubble, which peaked in 2000, particularly
amongst new technology companies. Second, the re-rating of
the Australian Dollar, related to the emergence of China and
International Investing in an Asset Allocation opportunities within asset classes in the attempt to add
additional value above that of the rest of the market (also known
Context as alpha). Both complement each other: SAA determines
International investing should form part of an overall asset whether an investor will reach their goal; TAA seizes
allocation decision. Asset allocation is ultimately about risk opportunities in an attempt to reach it faster.
management. A simple look at historical data reveals that an
asset allocation with the highest risk-adjusted return is not As an example, we outline our strategic asset allocations for a
particularly diversified (often a combination of the two or three Balanced investor in Australia, along with the expected
best performing asset classes). However, predicting future annualised return, volatility and probability of loss metrics
returns with accuracy is particularly difficult and it is necessary (Figures 36 and 37). The strategic allocations are based
to look at the best portfolio under a range of scenarios. Keynes (amongst other things) on forecasts of longer term risk and
is often quoted as having said, it is better to be roughly right returns for each asset class. The major difference between asset
than precisely wrong. allocations between retail and sophisticated clients is the
addition of alternative assets which create an additional layer of
A commonly quoted study on asset allocation by Brinson, Hood complexity that is best suited to sophisticated investors. The
and Beebower found that asset allocation explained, on average, choice within alternative asset classes is also considerably
93.6% of the variation in returns over time for US pension higher the larger the size of the investment pool.
funds. Security selection (e.g. which stock to buy) and market
timing (e.g. when to buy that stock) only explained 6.4% of For more information on our Asset Allocation offering, please
returns over time. A later study by Ibbotson and Kaplan in 2000 contact your Morgan Stanley Financial Adviser.
found that asset allocation decisions accounted for around 40% Figure 36: Retail Client SAA for a Balanced Investor
of the difference in performance between US mutual funds.
Either way, it appears that the eventual investment outcome (the
return and volatility experienced) is likely to be significantly
determined by the asset allocation chosen for ones portfolio.
Diversification through asset allocation allows investors to
achieve better risk-adjusted returns than via a single asset class.
The reason diversification adds value is that, by combining asset
classes with lower or negative correlations to each other, one is
able to eliminate a certain amount of risk. For example, as we
noted before, in a simplistic example, if an investor held a stock
and a bond, and the value of the bond rose 1% for each 1% fall
in the stock, then risk of the combined holdings would be
reduced.
Figure 35 shows some of the historical nominal correlations
between various International and Australian asset classes.
Figure 35: International versus Australian Asset Class
Correlations
Australian IG Australian Australian Figure 37: Sophisticated Client SAA for Balanced Investor
AREIT
Corporate Fixed Income Equities
International DM Sovereign 0.40 0.52 -0.10 0.17
International DM IG Credit 0.18 0.03 0.33 0.32
International Equity Return (AUD) 0.10 0.06 0.38 0.28
GREIT 0.18 0.15 0.51 0.51
Source: MSWM Research, Factset. Green shading shows lower correlations.

Red shading shows stronger correlations
Morgan Stanley Wealth Management offers suggested Strategic

and Tactical Asset Allocations for different investor profiles,
ranging from the Ultra-Conservative to the Aggressive investor.
The Strategic Asset Allocation (SAA) takes a longer-term view
of asset class risk and return characteristics with a view of
meeting investor risk tolerances and return goals, while the
Tactical Asset Allocation (TAA) looks at short-term
Part 2: Outlook for the Major International In our view, valuations are currently close to fair value for
Developed Market equities, so we expect only a very modest
Asset Classes further re-rating on aggregate. We note that forward valuations
are now close to the long-term average (excluding the tech
International Equities bubble) (Figure 40).
We use two building-block approaches in forecasting the
medium-term investment returns for international equities. The Figure 40: Forward World Equity Valuations Close to
first such approach forecasts a combination of dividend yield, Average
earnings growth, target valuation, and exchange rate. The
forward dividend yield is expected to average about 2.4% p.a
(Figure 38), well below Australia where we expect a yield of
4.3%, or 5.4% in gross-terms.
Figure 38: Forward World Dividend Yield Averages Around
~2.4%
Source: MSWM Research, Factset, MSCI World PE (IBES)
From a cyclically adjusted perspective, valuations are not

stretched and the current Case-Shiller PE is far from levels of
the tech bubble (30x) or the housing bubble (25x): Figure 41.
Figure 41: International Equity Valuations Remain Well
Source: MSWM Research, Factset Below Previous Bubbles
Our expectation for forward earnings growth is 6% p.a for
Developed Markets, in part reflecting aggressive share buy-
backs by a well-capitalised US corporate sector adding ~3% p.a
to US earnings growth. This assumption is similar to the long-
term average earnings growth of 6.3% p.a. for the combined
global index, and above the expected earnings growth for
Australia of 4.5% p.a.
Figure 39: Forward World Equity Earnings Growth
Source: MSWM Research, Factset, MSCI World PE using MSCI

calculation, real earnings adjusted by IMF World CPI
From an unhedged perspective, we expect the AUD to fall

against the basket of DM currencies by around 0.90% p.a. In
Figure 42, we note that the real effective exchange rate of the
AUD against its major trading partners is still elevated
compared to the long-term average.
Using expectations for dividends, valuation, FX and earnings
Source: MSWM Research, Factset, MSCI World PE using MSCI
calculation, real earnings adjusted by IMF World CPI growth, the first estimate for international equity growth is 9.6%
p.a. The same approach derives an expected return for
Australian equities of 10.1% p.a.
Figure 42: Australias Real Effective Exchange Rate

Remains Elevated
Source: MSWM Research, RBA
The second building-block approach to expected returns for

international equities uses a combination of the risk-free rate and
the equity risk premium. Our assumption for the international
(DM) equity risk premium (ERP) is 5.5%. This is slightly lower
than the Australian ERP of 6.0% due to the lower risk exposure.
Figure 43 shows that the current implied risk premium for the
MSCI All Country World index is roughly 6%, but this is
expected to normalise over time.
Figure 43: Historical International Equity Risk Premium
Depressed in Recent Times
Source: MSWM Research, Factset, Indices used are the MSCI World Ex
Australia Unhedged AUD
When added to the equilibrium risk-free rate assumption, and
our currency expectations (adding 0.9% p.a. to expected
returns), our estimate for international (DM) equity returns from
the risk-premium approach is ~11% p.a. This same approach
generates an expected return of 10.5% p.a. for Australian
equities.
Combining the expected returns for the two approaches, the
average international equity return is predicted to be 10.3% p.a.
For Emerging Markets, we assume a dividend yield of 2.7%, a
higher equity risk premium of 6.5%, higher earnings growth of
8% p.a and a valuation rerating of 1.5% p.a. to generate an
average expected return of 13% p.a.
International Listed Property For REITs, macro conditions, in particular the interest rate
backdrop (especially long-term bond yields), are important.
Property is an important asset class due to its ability to track
REIT performance is inversely correlated to global bond yields
inflation and generally provide a more defensive exposure to
(Figure 45). That is, lower bond yields (a bond market rally)
economic growth through rental income (though there are also
tend to benefit REITs as it lowers funding costs, tends to lower
property companies who generate more lumpy earnings from
asset cap rates (lifting asset valuations) and increases the relative
undertaking development). Nevertheless, the combination of
attraction of the yield offered by REITs.
inflation-linked properties and defensive rental income sets it
apart from fixed income investments that are exposed to Figure 45: REITs Performance Inversely Related to Bond
inflation risk, and from equities that are particularly sensitive to Yields
periods of macro-economic stress.
For most investors, the easiest exposure to property investment
is through listed vehicles, such as Real Estate Investment Trusts
(REITs), which pool investor funds together and overcome the
problems of high barriers of entry and lack of liquidity. A
limitation of listed vehicles though, is that they are more
correlated to equities, and are thus less of a diversifier. Like all
listed instruments, there is a degree of exposure to market
sentiment, and REITs can trade at a discount or premium to the
value of their underlying property (Net Tangible Assets).
During the GFC, the correlation between REITs and equities
rose significantly due to the higher levels of leverage that REITs
were then adopting.
Source: Datastream, MSWM Research
While Australia has a well-developed property securities market,
we are only a small part of the global market, which offers a Historically, Developed Market REITs have generated on
more diverse selection of assets. For example, constituents in average an 8.2% p.a. nominal return since 1990, though the
the FTSE EPRA/NAREIT Global REITs and non-REITs indices returns have been dragged down by heavy falls during the GFC.
alone have a combined market capitalisation of US$1.3tr of The GFC also meant REIT historic volatility has been
which the Australian REIT sector comprises only US$78bn, or particularly high, around 20%. Looking forward, however,
6%. Furthermore, offshore property exposures, particularly in given the amount of deleveraging we have witnessed in the
the US, can range from healthcare facilities to storage, to sector, we think this volatility will decline.
lodging, while Australian listed property has traditionally been For our long term forecasts, we assume that Global REITs return
focused on retail, office, and industrial properties. 9.1% p.a. with a volatility of 14% p.a. Within the returns
The GFC caused a number of Australian REITs to de-leverage forecasts, we assume global REITs provide an average yield of
and reduce the proportion of global property assets in their around 3.8%, in-line with the longer term average, along with
portfolio. Hence, beyond Westfield, Goodman Group and Lend some tailwinds from the depreciation of the AUD.
Lease, Australian property trusts now offer very little exposure Figure 46: Global Developed Market REITs Have
to offshore markets. Outperformed Australian REITs, $A Terms
Figure 44: Australian REITs Offer Limited International
Earnings Exposure (MS 2015 Estimate)
Source: Datastream, MSWM Research. Total Return Indices, re-based to

100. FTSE EPRA/NAREIT-Developed used for Developed Market REITs
Source: Company Data, MS Research estimates. Snapshot taken before the
WDC and WRT restructure in 2014.
International Fixed Income at the adjusted yield to maturity and changes to capital due to
changes within interest rates.
International Developed Market Bonds
The current yield to maturity for the International DM bond
Government bonds are traditionally viewed as the safest form of index (with a modified duration of 6.9) is around 1.4% p. a. In
investment beyond cash. The credit risk associated with our view, this yield is likely to rise as official interest rates
Government bonds is usually considered very low, though credit normalise over the next few years. Our assumption for yield is
rating downgrades by the ratings agencies since the GFC, and 2.5% p.a. over the investment cycle.
the Greek debt restructuring, have shown that this is not always
the case. The second form of risk associated with Government With current yields around 110bps below their equilibrium
bonds, is interest rate risk or duration risk (Figure 47). level, we expect an increase of 15bps p.a assuming reversion to
our equilibrium level of rates over the course of the investment
Figure 47: Government Bonds: Increasing Interest Rate cycle. With the modified duration of the International
Risk Government bond index at 6.9, we expect capital losses to
average ~1.0% p.a.
Long-term For 10-year bonds (as opposed to the bond index), our
High
Government Bond equilibrium yield assumption is just above 3.0%, obtained by

applying an 80bps term premium to our 2.25% cash return
expectation. This term premium is slightly below the 110bps
average of the 25 years preceding the GFC.
Interest Rate Risk
International currency exposures via international bonds are

Short-term Investment Grade
Low
Government Bond Corporate Bond

High Yield Bond typically hedged. This is because currency exposure is so
volatile that an unhedged bond investment becomes effectively a
currency investment. When hedging international bonds, the
investor often receives the FX carry that is determined by the
spread between short-term Australian and international inter-
Minimal
Investment Grade High Yield Floating bank rates. Due to the higher bill rate in Australia compared to
Cash Floating Rate Note Rate Note major developed markets, the FX carry is a source of extra
return on hedged international bond investments.
Minimal Low High

Our expectation for Developed Market Government Bonds
Credit Risk returns over the next 7 years is ~1.0% p.a hedged to USD
Source: MSWM Research according to our global colleagues. Our expectation for this
return hedged to AUD is 2.4% p.a based on an average 1.4%
The exposure to interest rate risk reflects the fact that spread between Australia and US yields (Figure 48).
Government bonds are issued with a fixed interest rate (or
coupon) for a fixed term. The attractiveness of this fixed Figure 48: A Narrowing Spread Between Australian and US
interest rate changes depending on expectations of future rates. Rates
When rates rise, the fixed rate previously bought is no longer as
appealing and vice versa. The value of a Government bond
investment is thus inversely related to changes in interest rates.
In addition, bonds with a longer-term to maturity are more
sensitive to deviations between current rates and the fixed rate.
A measure of the sensitivity of bond prices to changes to the
interest rate is called modified duration. Investors are
compensated for taking duration risk by receiving, on average, a
higher return above that of cash. This higher return is called the
term premium.
This asset class primarily includes Government bonds from
stable economies such as the US, Germany and the UK.
Government bonds issued by countries within peripheral Europe
and Emerging Markets are treated as sovereign credit (see next
section on credit) due to their much less credit-worthy nature. Source: MSWM Research, RBA
In determining long-term returns within International DM

Government bonds we use a building-block approach that looks
International Credit Another way to look at corporate credit is in relation to the

Fixed Income credit primarily encompasses debt that is issued degree of protection in the event of a corporate default. During
by corporations and certain sovereign nations. Unlike AAA- default, bondholders have a higher claim to assets than
rated Government bonds, the major concern in credit is whether shareholders. Within bondholders, investors holding secured
the issuer will pay the investor back. Credit worthiness is bonds have priority over unsecured bondholders. Within
assessed by credit rating houses which include S&P, Fitch and unsecured issues, there is a further hierarchy with senior
Moodys. unsecured bondholders having a greater claim than sub-
ordinated unsecured bondholders. All of these investors have
Investment Grade issuers have a credit rating of BBB and priority over shareholders (see Figure 50).
above for S&P and Fitch, and Baa and above by Moodys.
High Yield (or Junk Bond) issuers have a rating below these Figure 50: Hierarchy of Claims on Company Assets
thresholds (Figure 49). As the credit rating for an issuer
improves (with AAA or Aaa the highest rating), the likelihood
of default decreases.
Figure 49: Credit: Increasing Credit Risk
Long-term
High
Government Bond
Interest Rate Risk
Short-term Investment Grade

Low
High Yield Bond

Government Bond Corporate Bond
Source: MSWM Research
Investors can also invest in the sovereign credit of less

developed economies or the credit of advanced economies with
Minimal
Investment Grade High Yield Floating higher levels of indebtedness. Similar to corporate bonds, these
Cash Floating Rate Note Rate Note sovereigns may force bondholders to renegotiate debt payments
as a form of default risk, as we have recently seen in Greece.
Minimal Low High Other variations of credit instruments include securitised loans,
Credit Risk including asset-backed securities (ABS), mortgage-backed
Source: MSWM Research securities (MBS), and private mezzanine debt. Securitised loans
have an additional layer of protection depending on the tranche,
Credit can be structured in a variety of ways. Floating rate but can be sensitive to the value of collateral (as occurred during
credit can be issued with coupons that track underlying short- the GFC).
term interest rates. For these securities, there is minimal interest
rate risk. Private mezzanine debt is a direct private loan to a corporation
and is a mix between a high-yield bond investment and a private
Fixed rate credit investments such as corporate bonds are equity investment. Needless to say, private debt can be a
exposed to duration risk. Historically, investment grade credits particularly risky investment.
are issued with terms to maturity that are, on average, shorter
than their Government peers. Corporate bonds with a term to Drivers of Return
maturity of greater than 10 years are rare because of the Similar to Government bonds, the return on credit investments
combined risks involved. includes the coupon at issuance and changes within rate
Investments in credit achieve above cash returns by accepting expectations. In addition to this, returns are driven by changes
credit risk and default risk. While related, credit risk is the in credit spreads, and the recovery rate in the event of default.
risk that the issuers credit rating will deteriorate, lowering the Changes in a bonds credit spread can further be broken down
market price of the bond. Default risk is the risk that an investor into changes in the spread of the sector the issuer belongs to,
will not get back the full amount of their investment. and changes caused by the geographic spread.
Because of credit risk, corporate bonds need to pay a premium

to investors. This premium is called the credit spread. When
credit risk increases, the credit spread widens and the value of
the bond falls.
Figure 51: Investment Grade Credit Spreads have Narrowed In the GFC, credit spreads spiked higher, as the credit crunch
to Post-GFC Lows Across Geographies and economic downturn impacted credit quality and forced some
borrowers into default and restructurings (Figures 51 and 52).
Despite the moderate post-GFC recovery, however, profit
recoveries, balance sheet improvements and aggressive and
unconventional monetary policy has helped push credit spreads
to below average levels, and not far above pre-GFC lows
(Figures 53 and 54).
In forecasting future international credit returns, we use the
forecast returns derived by our global colleagues, and our own
hedging and volatility assumptions. For Developed Market
investment grade credit, returns are estimated to be ~2% p.a.
This implies a long-term equilibrium credit spread of ~1.0%,
which is around the long-term average. From a fully hedged
perspective, we expect returns to be around 3.4% p.a with
volatility at 6% p.a. For high yield credit, returns are assumed
to be 5.8% p.a. with a volatility of 8.5% p.a
Source: MSWM Research, Factset
The standard market practice for credit spreads is to quote by Figure 53: US Investment Grade Credit- Yield and Spread
reference to the LIBOR or Treasury curve. The most robust
definition of credit spread is the OAS (Option Adjusted Spread)
or the Z-spread in the case of bonds with no embedded options.
As an alternative to OAS, credit pricing can be made with
reference to a structural credit risk model which attempts to
calculate default probability directly by reference to the
volatility of a firms underlying assets and distance to default.
Expected Default Frequency and Distance to Default are risk
measures used to gauge structural risk.
In a similar way to Government bonds, corporate bonds are
priced with some reference to the corporate yield curve.
However, due to a much lower liquidity of credit (even with
investment grade issues), this curve plays a much less important
part in driving valuations than its more liquid Government Source: MSWM Research, Factset
cousin (where mispricing is quickly arbitraged away).
Figure 54: European Investment Grade Credit- Yield and
During periods of distress and likely default, corporate bonds are Spread
often priced with reference to the recovery rate, which is an
estimate of how much will be repaid to the bondholder relative
to the original face value invested.
Figure 52: Corporate Credit Default Swap Rates in the US
Alternative Assets Figure 56: Long Term Correlations for Alternative Assets
The concept of alternative beta as an asset class has been
gaining momentum as a replacement for hedge fund or
absolute return investments.
The majority of traditional asset classes derive their return via
some linkage to macroeconomic growth. Corporate profits and
financial health, rental yield, and the level of interest rates are all
impacted by macro factors. By contrast, investments within
alternative beta derive their returns from sources that are
unrelated to macroeconomic factors. These sources, based
primarily on market inefficiency, range from behavioural and
psychological sources to those that are structural and regulation
induced. Such returns provide diversification against traditional
asset class returns, such that a well-diversified portfolio of
traditional and alternative strategies allows investors to extract
returns even during periods of weak macro performance. Source: MSWM Research, Factset
Figure 55 shows the beta of various hedge fund strategies versus Drivers of Alternative Asset Returns
the ASX 200. Relative Value strategies are more than twice as
good a diversifier than Equity Hedge strategies. The driver of return from alternative strategies depends on the
risk premium that the strategy is leveraged to, including:
Figure 55: The Beta of Different Hedge Fund Strategies
1) Volatility Risk Premium
Volatility is important in driving the value of an option as
volatility increases, the value of the option increases due to the
greater likelihood of the option value being exercised. The
volatility that is used in pricing an option is called the implied
volatility while the actual market volatility is the realised
volatility. Historically, the implied volatility is higher than
realised volatility over time, which means the seller of the
option normally extracts a premium for providing the risk-
management service (Figure 57). The volatility premium
compensates the option seller for taking the risk that volatility
will increase.
Figure 57: Implied Option Volatility Typically Exceeds
Source: MSWM Research, Factset. 1990 Now. Realised Volatility
60
In the alternative asset space, manager or strategy selection is
very important. For example, a hedge fund that is 50
predominantly long the equity market perhaps offers more of an
equity exposure than alternative beta. Indeed, the GFC showed 40
that many hedge funds were actually just generating returns via
traditional macro beta as correlations were high against the 30
MSCI World Index (Figure 56). On the other hand, other hedge
fund strategies (e.g. managed futures) offer diversification 20
benefits that are higher than what is achievable in traditional

asset classes. 10
0
2006 2007 2008 2009 2010 2011 2012 2013
Implied Volatility (3M ATM) Historical Volatility (60D Parkinson)
Source: MSWM Research, Bloomberg. ASX200
2) Carry Risk Premium

Differences in preferences between buyers and sellers often lead
to inefficiencies within the futures market. Carry refers to the
return gained from holding a security over time and moving Returns in an Historical Context
down the futures/forward curve. For example, given a normal
yield curve, a long future position will eventually appreciate The HFRI group of indices is most commonly used in analysing
over time if the curve does not change. Historically, this is hedge fund performance. However, this index is plagued with
observed in the fact that the 3M USD LIBOR forward rate is issues: not all hedge funds provide performance data; poorly
usually higher than spot LIBOR rates (Figure 58). performing funds often opt to hide their performance data;
poorly performing hedge funds leave the industry and stop
3) Liquidity Risk Premium reporting performance. One of the methods to combat this
survivorship bias is to track the performance of a fund of hedge
Liquidity risk is inherent in many asset classes. One of the
funds index.
simplest ways to gain access to the liquidity premium is to
invest in illiquid assets such as real estate and private equity. During the uncertain markets that have existed since the GFC,
While the additional return generated is significant, the liquidity hedge fund returns have been poor. Indeed, performance in the
risk premium is often not a great diversifier due to the strong 00s was only slightly above inflation with a 0.9% real return
correlation to the equity risk premium via linkages to systemic due to a large 24.5% fall in 2008 (in real terms). While the 2008
risks. fall was not as much as in equities, it was evidence that, despite
their absolute return focus, hedge funds were impacted by equity
4) Event Risk Premium
markets as a whole. This poor performance was then
Event risk premium is the primary source of income for event- compounded in 2011 with the 2nd worst down year since 1990,
driven hedge funds. This premium compensates investors for with a fall of 8.0%.
taking risk on the outcome of a binary event, such as a merger
One of the often ignored characteristics of hedge funds is that
announcement. The market typically reacts to the
their volatility of returns has historically been lower than
announcement by buying shares up to near the deal price, but
equities and commodities. Since 1990, hedge fund volatility has
below the deal price due to the possibility that the deal will not
averaged around 11%. This is because of the multitude of hedge
proceed. This difference is the deal spread and this spread
funds that employ strategies in defensive assets like fixed
typically trades in a narrow band during the merger
income and control their risk levels very closely.
consideration. Event-driven hedge funds invest in this deal
spread with the view that the deal will eventually go ahead. Historically, the best performing hedge fund strategy since 2000
is Event Driven and Relative Value (Figure 59). Macro hedge
Figure 58: Carry Risk Premium in the USD 3-Month Libor
funds were particularly strong during the GFC, returning 4.83%,
Market
while the rest of the hedge fund family became more equity-like.
Figure 59: Historical Hedge Fund Annual Returns by Style
Year Fund of Funds Equity Hedge Event Driven Macro Relative Value
2000 4.07% 9.09% 6.74% 1.97% 13.41%
2001 2.80% 0.40% 12.18% 6.87% 8.92%
2002 1.02% -4.71% -4.30% 7.44% 5.44%
2003 11.61% 20.54% 25.33% 21.42% 9.72%
2004 6.86% 7.68% 15.01% 4.63% 5.58%
2005 7.49% 10.60% 7.29% 6.79% 6.02%
2006 10.39% 11.71% 15.33% 8.15% 12.37%
2007 10.25% 10.48% 6.61% 11.11% 8.94%
2008 -21.37% -26.65% -21.82% 4.83% -18.04%
2009 11.47% 24.57% 25.04% 4.34% 25.81%
2010 5.70% 10.45% 11.86% 8.06% 11.43%
2011 -5.72% -8.38% -3.30% -4.16% 0.15%
2012 4.79% 7.41% 8.89% -0.06% 10.59%
2013 8.96% 14.28% 12.51% -0.44% 7.07%
YTD 2014 4.97% 8.89% 8.73% -0.38% 6.75%
Since 2000 4.68% 6.88% 9.45% 6.33% 8.79%
Source: Barclays
5) Momentum Risk Premium
Long-Term Capital Market Expectations
Momentum is a well-documented phenomenon in many
financial markets. The market does not always react to data Returns from alternative beta are highly dependent on the
quickly due to a behavioural inefficiency of anchoring, and a strategy utilised. MSWMs Global Investment Committee
structural inefficiency due to transaction costs. The momentum expects the diversified hedge fund universe to return 7% p.a.
risk premium compensates investors for being the first to We use a lower 5.4% p.a, which is around an average of the
respond to a change in the status quo. Managed futures (or CTA GICs assumption and the historical performance of fund of
funds) provide investors with exposure to this, given the low funds.
transaction cost of futures compared to the underlying securities.
Part 3: Outlook for the Major International x The Low US Dollar: the US Dollar remains at extremely
Regions competitive levels against global peers.
x Substantial Pent-up Demand: Housing Starts, for
The United States example, are about two-thirds of normal levels. Similarly,
whilst vehicle sales are at 7-year highs, they are only
Figure 60: Key Economic Data and Forecasts around replacement levels. Net business investment is also
UNITED STATES 2012a 2013a 2014e 2015e at depressed levels, with capital per worker flat for an
Real GDP Growth %YoY 2.8 1.9 2.1 2.8 unprecedented 5 years.
Inflation (CPI) %YoY 2.1 1.5 1.9 1.7
Unemployment Rate* % 7.8 7.0 5.9 5.4 x New Secular Growth Drivers: the shale energy industry is
Monetary Policy Rate (end of period) % 0.13 0.13 0.13 0.13
a strong driver of growth, more than doubling the share of
General Govt Surplus (Deficit) / GDP % -6.8 -4.1 -3.1 -2.9
Gross General Govt Debt / GDP % 99.7 101.8 102.9 103.6
Drilling & Mining investment over the past decade to 7%
of total investment. Low energy and attractive relative unit
Source: Bureau of Economic Analysis, MS Research forecasts, *4Q average labour costs are driving some reindustrialisation.
The US Still Leads the Global Economy x Improving momentum: US employment growth, currently
Despite an extended period of moderate-or-worse growth, the rising at around a 2% rate, appears increasingly robust.
US is still the dominant global economy, representing ~23% of Inflationary pressures remain moderate, despite some signs of a
current dollar world GDP, and ~19% in Purchasing Power Parity trough. The labour market retains significant slack, despite a
(PPP) terms. Private Consumption dominates the US, making decline in the headline unemployment rate, with wage growth
up 68.5% of total GDP- business and residential investment are remaining low at ~2%YoY. Residential rental inflation is
just 12.1% and 3.1% respectively. slowly building as the housing market recovers, while deflation
Economic Outlook: Stronger, Sounder & More in core goods prices has ended.
Sustainable Figure 61: US Housing Activity: Headwind to Tailwind at ~
Two-Thirds Normal Levels
After one of the worst winters on record in 2013-14, the US
economy has enjoyed a strong Spring rebound. We forecast
strong growth in 2H14 and 2015 for seven reasons:
x Headwinds now Tailwinds: imbalances that have held
back the US recovery have been resolved, including: i)
household leverage (debt ratio from 130% to a 12-year low
103% of disposable income); ii) household debt burdens
(service ratio from 13.2% to a record low 9.9%); iii)
banking system liquidity and capital ratios (Loan-to-
Deposit Ratio from 103% to a multi-decade low 76%); iv)
Housing Vacancy rate (from a peak of 11.1% to a near-
average, 13-year low 8.3%); and v) the Federal Budget
deficit from 6.8% of GDP in F2012 to a CBO-estimated
2.8% in F2014 (Figure 62). Source: Bloomberg, MSWM Research
x Persistent Super-Easy Monetary Policy: the Federal Figure 62: US Federal Budget Outlook- Dramatic
Reserve has been tapering its pace of asset purchases under Improvement
QE3 since January, and is on-track to end QE3 in October.
Nonetheless, policy remains super-accommodative, with
the zero nominal Fed Funds rate expected to last well into
2015. Negative real short rates and the steep yield curve
should last much longer.
x Less Fiscal Tightening: the fiscal cliff deal and
sequestration in 1H13 led to the sharpest fiscal tightening in
40 years. Following the Government shutdown in October
2013, the 2-year budget deal and debt limit extension until
March 2015 cut fiscal risks and limited tightening. State &
Local Government budgets are in their best shape since the
GFC, assisted by the recovering property market. This is
leading to a gradual recovery in Government employment.
Source: CBO, MSWM Research
Equity Market Outlook assisted by persistent low wage growth and locked-in cheap
long-term borrowings, though a stronger US Dollar should be a
Despite trading around record levels, we remain positive on the partial offset.
US equity market, given super-accommodative liquidity
conditions, attractive relative valuation, solid earnings growth, Equity Supply-Demand: Still Positive- US corporates continue
and attractive supply-demand fundamentals. to aggressively buy-back their own stock, announcing US$568
billion of buybacks in 2013, up 21%YoY. In addition, the
Liquidity Conditions: Super Accommodative- Zero nominal corporate activity cycle is gradually accelerating, supported by
short rates, negative real short rates, and the steep yield curve all strong balance sheets (including US$1.7 trillion of cash), low
point to positive liquidity conditions. Morgan Stanley expects corporate bond yields and average valuations.
the Fed to leave rates at zero until 1H16, while the market
expects a first move in mid-15 (Figure 63). As such, the threat Fixed-Income Outlook
of a material shift in liquidity conditions appears low near-term.
Despite a strong Spring rebound in US economic indicators,
Figure 63: 12 Months to 1st Fed Rate HiKE (M1KE) near 3-year highs in Euro-Area business surveys and QE3
tapering, US long-term bond yields have actually fallen in 2014.
We attribute this to fears that the economy will soften without
emergency Fed support- as occurred at the end of QE1 and QE2-
dovish comments from new Fed Chair Janet Yellen, geopolitical
risks in the Ukraine and Iraq, and market positioning.
Nonetheless, we expect a gradual rise in yields as strong US
growth continues into 2H14 and beyond the end of QE3, and
there is a gradual pick-up in underlying US inflation.
Corporate bond spreads are approaching pre-GFC lows. Whilst
strong corporate fundamentals are likely to persist, we expect
management and Boards to reward shareholders over
bondholders going forward. So with Treasury yields rising, and
spreads likely to be flat-to-moderately higher, we expect
Source: Morgan Stanley Research, CME-CBOT, Federal Reserve corporate bonds to also underperform.
Valuation: Fair in Absolute Terms; Attractive in Relative Figure 65: US Bond Yields have Fallen in 2014, But Equities
Terms- the US Forward PE has re-rated from a post-GFC low have Rallied, a Contrast to the End of QE1 and QE2
of ~12x to around the long-term low-inflation average of 15.5x.
When compared to interest rates, short or long-term, the equity
market appears very attractive. While the Shiller PE, a long-
term valuation metric using 10-year real earnings, seems less
attractive, in our view the GFC currently distorts this metric.
Figure 64: Equity Valuations Very Attractive vs Rates
Source: IRESS, MSWM Research
Key Catalysts and Risks to Watch:

Key catalysts include the strength and breadth of growth in
2H14, indicating the resilience of the economy without QE3.
Source: Factset, Bloomberg, MSWM Research
Wage and other labour market indicators of inflationary pressure
will influence the timing of the 1st Fed tightening.
Earnings: Robust Outlook- whilst US earnings are at record
levels, our economic outlook points to further robust earnings Key risks include a stifling of the housing recovery by overly
growth. Indeed, accelerating US GDP growth should further lift tight home mortgage lending standards, the improving outlook
top-line growth and operating margins. Margins should be not driving a rise in business investment and a renewal of the
disruptive fiscal fight in 1H15 (debt limit and budget).
Euro Area and United Kingdom sheets; a normalisation in asset quality seeing reduced
provisioning; and reduced funding stresses boosting bank
Figure 66: Key Economic Data and Forecasts margins.
EURO AREA 2012a 2013a 2014e 2015e x Ongoing support from Monetary Policy: the ECB has
Real GDP Growth %YoY -0.6 -0.4 1.0 1.5 dropped interest rates to record lows (with deposit rates for
Inflation (CPI) %YoY 2.5 1.4 0.5 1.2 banks now negative), and provided additional liquidity
Unemployment Rate % 11.3 12.0 11.7 11.4 through multiple tools a Securities Markets Programme,
Monetary Policy Rate (end of period) % 0.75 0.25 0.15 0.15 Outright Monetary Transactions, and more recently
General Govt Surplus (Deficit) / GDP % -3.7 -3.1 -2.7 -2.6 additional Targeted Long Term Refinancing Operations
Gross General Govt Debt / GDP % 90.8 92.7 93.0 93.0 (LTRO). In our view, full-blown Quantitative Easing is
unlikely given the political hurdles, uncertainty in its design
UNITED KINGDOM 2012a 2013a 2014e 2015e and structure, and questionable economic benefits, unless
Real GDP Growth %YoY 0.3 1.7 3.1 2.7 the recovery is in danger of de-railing or deflation becomes
Inflation (CPI) %YoY 2.8 2.6 1.6 1.7 a more significant concern.
Unemployment Rate % 7.9 7.6 6.6 6.2
x Tentative signs of the recovery: gauges of manufacturing
Monetary Policy Rate (end of period) % 0.50 0.50 0.50 1.25
activity have moved back into expansion territory;
General Govt Surplus (Deficit) / GDP % -5.3 -6.0 -5.1 -3.8
Consumer, economic and business sentiment have turned
up; and ECB lending surveys also show that fewer banks
Source: Eurostat, ONS, BoE, MS Research forecasts expect to tighten credit standards. The prolonged decline in
Europes Share of the Global Economy in Decline investment spending since the crisis may also have created
pent up investment needs with the investment ratio running
Europes (UK and Euro Area) share of the global economy at 17.6% of GDP compared to a historical ratio of 20.2%,
appears to be in structural decline, reflecting negative and a depreciation rate of 16.4%.
demographics and poor productivity performance. As a share of
current dollar world GDP, Europe has fallen to ~23%, down Figure 67: A Significant Drop in Sovereign Credit Spreads
from 32.9% in 1990. In PPP-terms, the decline is equally
pronounced, from 28.2% in 1990 to ~18.5% currently. By
industry, as with other Advanced Economies, Europe is largely
service-based, with services representing around 75-80% of
GDP. By expenditure, private household consumption is around
60-65% of GDP.
Economic Outlook: A Muted Recovery in the Euro
Area and Sustainable Growth in the UK
We believe the Euro Area has now come through the worst of
the credit crunch of 2010-12. We are cautiously optimistic on
its near term outlook, reflecting the following:
x Financial Conditions have eased: reflecting a fall in Source: Bloomberg, MSWM Research
interest rates and bond yields, and a compression in credit
spreads in the periphery countries (Figure 67). In many Figure 68: Fiscal Balances Improving, But Further Reform
cases the retracement has seen absolute yields fall below Needed
levels seen prior to the GFC, easing funding cost pressures
for Governments. This should eventually feed into a
reduced cost of capital for companies.
x Fiscal reform is occurring: The Euro Area reached a
significant target in 4Q13 when its combined budget deficit
fell below 3% for the first time since 2008. Better budget
outcomes amongst the periphery economies have driven a
number of upgrades to their credit ratings and outlooks.
Key countries like Spain, Ireland and Portugal have
recently exited their bailout programs.
x Banking sector repairing balance sheets: Key to the
economy is the health of the banking sector. Banks are
Source: IMF, MSWM Research. 2014 and 2015 Forecasts are deficits/GDP
expected to benefit from further re-capitalisation of balance
However, growth in the Euro Area is likely to lag other major mutual funds also continue to see flows into equities. On the
economies for a number of years. The de-leveraging process in other hand, M&A activity in the UK has failed to gather steam,
the non-financial private sector has been limited and there is a and the equity market is being kept well supplied with a steady
need to implement further structural reforms (targeted at stream of IPOs.
boosting investment, hiring, and/or enhancing global
Figure 69: Earnings Yields Still Attractive Relative to Bond
competitiveness) to boost growth. If not, growth is at risk of
Yields
stagnating, creating serious consequences for longer term fiscal
sustainability. Pursuing these reforms as well as fiscal
consolidation, without undermining the recovery, will be the
biggest challenge.
Growth in the UK is expected to outstrip the Euro Area.
Reasonable growth should continue into 2015, led by continued
strength in business investment, housing (given historically low
interest rates and extension of the Governments Help to Buy
scheme), and improved labour market conditions. However,
with fiscal austerity likely to increase in 2015-16, the likelihood
that the Bank of England will start raising rates in 1Q15, and
potential further tightening in macro-prudential policy to limit
financial system risks, growth may slow from current rates. On
the flip side, the UKs fiscal deficit should narrow further.
Source: Datastream, Bloomberg, IBES, MSWM Research
Equity Market Outlook
Overall, the backdrop for European and UK equities, which are
Fixed Income Outlook
yet to recover to their pre-GFC peaks, is positive. A divergence Euro Area sovereign bond yields, particularly in the South, have
in monetary policy though, may see more support for Europe declined significantly since mid-2012 as the regions recovery
over the UK. Morgan Stanleys European Strategists forecast 8- gained momentum, aggressive monetary policy was pursued,
10% return over the next 12 months on the MSCI Europe and progress on fiscal consolidation was achieved, and investors
FTSE indices. sought yield in a low interest rate environment.
Liquidity Conditions: Super Accommodative but Risk of Morgan Stanleys rate strategists currently forecast a further
Diverging interest rates are at record lows in both Europe and mild compression in spreads in southern Europe due to
the UK. The Central Banks have also injected liquidity in improving economic fundamentals, an attractive carry in a low
different ways the BoE through its 375bn QE program, and yield environment, and potential for positive ratings actions.
the ECB mainly via LTROs to the banks. However, with However, the pace of spread compression should slow and will
deflation still a real threat in Europe and growth lagging, the largely be offset by German Bund yields which are expected to
ECB is unlikely to withdraw this liquidity or raise rates until rise in sympathy with yields in the US and UK and which are
well after the UK and the US. already trading at record low levels. This should leave most
Euro sovereign yields outside of German Bunds largely
Earnings: Increased Conviction - with more confidence that unchanged over the next year or so. In the UK, gilt yields are
the Euro Area has returned to growth and less of a drag from an expected to rise led by the front-end into the first rate hike, and
elevated Euro, this should increase conviction on the earnings therefore will likely underperform.
growth outlook. Morgan Stanleys European Strategy team
forecasts 8% EPS growth in 2014 and 12% growth in 2015 a Key Catalysts and Risks to Watch
turnaround from the c.1% earnings decline in 2013. UK Key catalysts Euro-Area: execution of structural reform;
earnings likewise, are expected to grow 8% in 2014 and 10% in further ECB monetary easing against a backdrop of other central
2015, compared to a 9% decline in 2013. banks tightening, driving a lower Euro; and, as with the UK,
Valuations: Constructive: Europe and the UK currently trade earnings downgrades moderating, shifting focus towards
around a 13.5-14.0x PE multiple, largely in line with their long- earnings growth. UK: further catalysts may involve a pick-up in
term average, and at a discount to the US, reflecting the lower wages growth which in turn drives consumer spending.
conviction around their growth outlook. As conviction around Key risks - Euro-Area: increasing presence of Euro-sceptic
earnings increases, we see scope for a mild re-rating. The political parties in the Euro Parliament hinders progress on
earnings yield to bond yield gap remains wider than normal region-wide reforms; deflation becomes entrenched and in turn
keeping equity valuations relatively attractive (Figure 69). concerns about fiscal sustainability resurface; the Euro continues
Equity Supply-Demand: Distinct differences - M&A activity to appreciate, creating a headwind to growth; or complacency
appears to be on the increase in Europe, with companies shifting sees a lack of progress on deficit reduction or structural reform.
from saving cash to spending it, driving the average deal size UK: the key risk is one of policy error (in raising rates too early
sharply higher from about $700m to nearly $1bn. European or too late and macro-prudential).
Japan Tight Labour Market, Weak Wage Growth: Japans labour

market is clearly improving. The unemployment rate has
Figure 70: Key Economic Data and Forecasts recently fallen to as low as 3.5% (lowest level in more than 15
years) and the ratio of job-offers-to-seekers has exceeded 2007
JAPAN 2012a 2013a 2014e 2015e levels. The concern, however, is that despite tighter labour
Real GDP Growth %YoY 1.9 1.6 1.1 1.1
conditions wage growth has been weak and in real terms is
Inflation (CPI) %YoY -0.1 0.4 2.7 1.8
Unemployment Rate % 4.2 3.7 3.8 3.4
rapidly falling real wages fell 3.8% YoY in May 2014, hurt by
Monetary Policy Rate (end of period) % 0.10 0.10 0.10 0.10 the tax rise. If real wage growth doesnt pick up, it could
General Govt Surplus (Deficit) / GDP % -10.2 -9.8 -8.3 -6.5 undermine the economic recovery.
Next Steps on the Reform Agenda: Abes second growth
Source: Cabinet Office, MS Research forecasts strategy was announced in late June 2014. Recommended
reforms included a cut in the corporate tax rate (currently 35%,
Japan: Sharp Decline in Share of the Global Economy the second highest in the OECD), increased immigration,
Despite two decades of sub-par growth and deflation, Japan is proposals to reduce female underemployment, and steps to
still one of the largest economies in the world. In current dollar strengthen corporate governance. Morgan Stanley Economist
terms it makes up ~8% of global GDP with an economy that is Robert Feldman thinks the direction and the content of the
primarily dominated by domestic consumption - private and agenda is clear; the issue (for the moment) is speed of
Government consumption making up ~60% and ~20% of total implementation.
GDP respectively.
Figure 71: Inflation Spiked in April following the
Economic Outlook: Aiming for Escape Velocity Governments Move to Raise the Consumption Tax
Japan has been trapped in a deflationary cycle since the early
90s, but policy measures (namely fiscal stimulus and monetary
easing) implemented shortly after PM Shinzo Abes election in
late-2012 have been showing nascent signs of success. Inflation
has been tracking higher, more recently swelled by a
consumption tax increase and rising utility prices - core CPI (ex-
food) reached a 32 year high of 3.4%YoY in May 2014 (Figure
71). However, if you exclude the consumption tax, inflation has
slowed to 1.3%YoY in June (from 1.5%YoY in April.)
By comparison, progress on the third arrow, structural reform,
has been much slower and largely disappointing. As a result,
2014 will prove to be a crucial test for Abenomics as it will
determine whether Japan can implement the policies necessary
to lay a foundation for prolonged economic growth. We outline
the key challenges we see facing the economy.
Source: Bloomberg, MSWM Research
Weathering the Consumption Tax Increase: To help raise
Figure 72: Retail Sales and Consumer Confidence are
Government revenue and reduce public debt (gross Government
Picking up After Bottoming in April 2014
debt stands at ~245% of GDP) the countrys consumption tax
was raised from 5% to 8% on April 1st, 2014. Despite fiscal
stimulus to offset the tax, the net effect of this policy should be
weaker growth. The last time this tax was raised (from 3% to
5% in 1997) Japan was tipped into recession. Morgan Stanley
economists estimate that negative GDP growth in April-June is
now almost a certainty. While they do not expect the economy
to fall into recession, the key question remains, how quickly will
the economy recover in the third quarter?
Encouragingly, key economic indicators are showing signs of
stabilising after the post-tax slump in April. Consumer
confidence has picked up and retail sales have rebounded to be
almost flat year-on-year (Figure 72). Manufacturing has also
proven to be resilient, with the recent Tankan survey solidly
positive and the Manufacturing PMI rebounding from an April
low of 49.4 to slightly above the 50-level.
Equity Market Outlook Equity Supply-Demand: Seeing Dramatic Improvement -

The outlook for the Japanese equity market looks promising Record levels of cash on company balance sheets, cheap shares
given attractive valuations and several positive catalysts that are and a Government-led initiative to improve return on equity
expected to play out in 2H2014. These include: i) further easing (ROE) is driving increased buyback activity on the Topix. Since
by the Bank of Japan (BoJ); and ii) an announcement by the the beginning of the year 152 companies on the Topix have
Government Pension Investment Fund to allocate a greater announced buybacks worth 2.5 trillion, easily beating a
portion of its bond-heavy portfolio towards equities. previous high of 1.5 trillion reached in 2008. Rising levels of
buyback activity are another source of support for the equity
Liquidity Conditions: Extremely Accommodative Unlike market.
the US where QE is likely to come to an end later this year,
Japan is at a much earlier stage of the monetary easing cycle and Fixed Income Outlook
is still actively increasing the size of its monetary base (the BoJ Long-term Japanese Government bond (JGBs) yields have been
has pledged to increase its monetary base by 60-70 trillion in a steady decline since mid-2008. This rally in JGBs enjoyed
p.a.). Moreover, given our expectation that the BoJ is likely to another leg up when the BoJ introduced QQE in April 2013. At
increase the scale of Quantitative Qualitative Easing in 2H14, 0.57% long-term Japanese bond yields are approaching
liquidity is expected to remain abundant on a medium term historical lows, and in real terms their yield is now firmly
view. negative. Real yields have been in decline since inflation moved
into positive territory in late 2013 (Figure 74).
Valuation: Attractive in both Absolute and Relative Terms -
Following a solid equity market rally and associated PE rerating Given the BoJs commitment to ease policy as long as it is
in 2013, since the start of this year Japanese equities have de- necessary to reach and maintain its 2% CPI target, nominal and
rated. At a forward PE of 13.8x, Japanese equities are cheap in real yields are likely to remain low. While in nominal terms we
absolute terms and relative to their own history. Moreover, expect bonds to deliver positive returns, we expect that relative
Japans consensus forward PE is trading at a massive ~8.0% to Japanese equities, they will underperform.
discount to the MSCI World index. As highlighted in Figure 73,
Figure 74: Real Yields on Japanese Government Bonds are
current valuations reflect the largest relative discount to the
Negative and Likely to Continue to Remain Low
MSCI World index in a 25 year period.
Figure 73: Japan Forward PE at Attractive Levels
Source: Bloomberg, MS Research
Source: DataStream, MSWM Research Key Catalysts and Risks to Watch:

One of the biggest risks to the economic recovery is that the
Earnings: Going Strong - Earnings grew by ~50%YoY in
Japanese administration fails to implement the key reforms
2013, lifted by the weaker Yen. Year to date (to the end of June
outlined in the June growth strategy. Speed of implementation
2014) earnings have risen ~14%. Further upside is likely to be
is another important consideration if the market deems
supported by a further weakening of the Yen and the delivery of
progress on reforms as too slow, equities are likely to
promised corporate tax cuts. While the increase in the
underperform. Other risks include a lack of adequate monetary
consumption tax is a near term headwind, any sustained
stimulus by the BoJ, a sustained decline in consumer spending
slowdown in economic growth would likely be countered with
following the introduction of the consumption tax, and a failure
BoJ intervention. The biggest risk to earnings is that real wages
of wage growth to keep up with inflation, both of which could
fail to catch up to rising levels of inflation. While more recently
undermine the recovery.
we have seen a pick-up in wages (which should continue to rise
as the labour market tightens), wage growth will need to
accelerate from current levels to keep up with rising inflation.
Figure 76: Fragile Five EM have seen Substantial Currency

Emerging Markets Depreciations, Helping Close Imbalances
Figure 75: Key Economic Data and Forecasts
Source: IMF, MS Research forecasts
Emerging Markets: Growing Share of the Global

Economy
Since the end of the Cold War, EM has grown dramatically as a
share of world GDP: from 23% to 46% using current exchange
rates, and from 37% to 57% on a PPP-basis. Looking ahead
these trends should continue, with Morgan Stanley projecting Source: Bloomberg, MSWM Research
real GDP growth to average 5.3% p.a from 2015-18.
Figure 77: Fragile Five EM Rate Tightening- Helping
Economic Outlook: Growth Bottoming Out Prepare Ahead of Expected Fed Tightening
Measures to curb Chinas shadow banking system and property
markets, and concerns about structural imbalances in the Fragile
Five (Brazil, India, Indonesia, Turkey and South Africa) have
combined to lower EM growth in 2013-1H2014. However,
growth appears to be bottoming out, given:
x Low-Profile Easing in China: monetary easing including a
targeted 2ppt cut to reserve requirements and a decline in
Shibor rates; fiscal stimulus including accelerated
infrastructure investment and SME tax cuts; regulatory
easing of some property controls in more than 20 cities.
Recent data is showing some signs of improvement.
x Easing Funding Pressures: the rally in EM asset markets
and DM bonds has eased local and external funding
pressures.
x Stronger DM Growth Beginning to Assist EM
Exporters: Chinas exports (ex-HK) are up 8.4%YoY (3- Equity Market Outlook
month moving average)- export performance has also We are positive on Emerging Markets, given improving
improved in Korea and Taiwan. liquidity conditions, very attractive valuation, solid earnings
upside as growth troughs and moves higher, and potential for
x A Dovish Shift in Monetary Policy: in addition to the fund inflows.
PBOCs easing measures, Morgan Stanley expects rate cuts
in India, Korea, Thailand and, eventually, Russia. That Liquidity Conditions: Becoming Supportive- after sharp rate
said, rates are expected to rise in 2015 in Brazil and South rises in parts of EM in 2013-to-early-2014 on fears of tightening
Africa. in the US, liquidity conditions have eased in recent months
(Figure 78). In particular, China has eased policy, with targeted
x A Market-Positive Election results in India and Reserve requirement cuts and lower interbank rates leading to a
Indonesia: the election of the Modi-led BJP in India and pick-up in M2 growth.
Joko Widodo in Indonesia are seen as a pro-business
development. Valuation: Attractive- EM is trading on a Forward PE of less
than 11x, below its long-term average of 13.2x. The ~32%
Altogether, Morgan Stanley expects growth to trough at ~4.5% discount to the US is well above the ~23% long-term average
in 2Q14 and to rise to 5.2% in 2015. (Figure 79). The discount has only been wider in the aftermath
to the EM crisis of 1997-98. Relative Price-to-Book is also the
most attractive in a decade (Figure 80). While not as extreme as
in DM, valuation also appears attractive versus rates.
Figure 78: China- Historically Lending and RRR Cuts have Equity Supply-Demand: outflows from Emerging Markets
been Associated with Market Troughs funds have been substantial over the past 18 months, totaling
more than US$60 billion (Figure 81). Modest inflows have
restarted in recent months.
Figure 81: Flows to Dedicated EM Equity Funds Have
Recently Stabilised, After Heavy Outflows 13-Early-14
Source: CEIC, RIMES, MSCI, Morgan Stanley Research. Data as of June

23, 2014
Figure 79: EM at a Large ~32% Discount to the US
Source: EPFR Global, Fund Flows Database. Data as of June 18, 2014,
Morgan Stanley Research
Outlook in Key Markets

Morgan Stanley remains Overweight MSCI China, despite
weakness in 1H14 macro data and earnings revisions. We think
these are more than priced into the equity market, with the China
Forward PE relative and Global Emerging Market fund
managers ownership levels at 5-year lows. Catalysts for a turn
in sentiment and valuations are: a) China's structural reform
agenda and b) a policy-easing cycle, which is gradually
becoming more evident. On Taiwan, we forecast better-than-
expected exports to DM and private consumption recovery to
Source: Factset, Bloomberg, MSWM Research drive the improvement in corporate ROE.
Figure 80: EM Cheapest to DM on Price to Book Value In India, we are adopting a Trust but Verify framework
Since Mid-04, But ROE Relative is Declining similar to that used when assessing the incoming Abe
administration in Japan. India is the most over-owned market in
APxJ/ EM, currently trading above long-run average valuations
but still below peak multiples. For Indonesia, we expect the
Jokowi victory to be positive for the market.
We retain Underweight recommendations on Brazil, South
Africa, Thailand and Turkey, all of which have unresolved
current account imbalances and / or structural challenges and
political risk dynamics that are likely to play out in the form of
downward pressure on currencies and higher bond and equity
market risk premiums in 2H14. This view is predicated on our
fixed income teams expectation that core government bond
yields resume a rising trend in 2H14. Moreover, there is a
likelihood of an incumbent victory in Brazils presidential
election at this stage.
Source: Factset, Bloomberg, MSWM Research
Key Catalysts and Risks to Watch:
Earnings: Robust Outlook- a modest acceleration in EM
growth, stronger DM growth and falling commodity prices are Key catalysts include policy easing and reforms in China,
positive for the earnings outlook, particularly among the export- removal of election uncertainty, and a return to fund inflows.
focused manufacturers of Asia.
Part 4: The Major Risks Figure 82: The Australian Dollar- Typically the Most
Volatile of the Dollar Bloc Currencies
The key risks to international investing can be divided into long-
term, secular risks and shorter-term cyclical risks. The long-
term secular risks include the volatility of the Australian Dollar,
the structural challenges confronting many Developed
Economies, transition challenges facing many Emerging
Markets, and geopolitical risks. In the shorter-term, the key
risks include the process of policy normalisation led by the US,
the deflationary threat in Europe, a China hard-landing and the
risks of other fragile Emerging Markets.
Historically the Australian Dollar has been particularly volatile,
rising and falling with global growth cycles and associated
swings in commodity prices. It has typically been the most
volatile of the Dollar Bloc currencies (Figure 82). In this sense,
it acts somewhat like a natural hedge, declining in periods of
equity market weakness and vice versa. Source: Bloomberg, MSWM Research
The structural challenges confronting many Developed Markets Figure 83: The US Feds Balance Sheet- How Will it be
include ageing demographics and high levels of debt. The Unwound?
negative demographics are most pronounced in Japan and parts
of Europe. Whilst private sector deleveraging has been
pronounced in many countries since the GFC, particularly in the
US, UK and Spain, most countries have seen a dramatic rise in
national debt. When these challenges are combined they act as
deflationary forces within economies.
Furthermore, negative demographics when combined with poor
levels of investment since the GFC are adversely impacting
potential GDP growth rates among many Developed Economies.
In the US, for example, the labour force participation rate has
fallen to the lowest levels since the 1970s, partly reflecting the
ageing population. Furthermore, weak business investment has
led to an unprecedented 1.2% decline in capital per worker over
the past four years. Without action to arrest these trends,
Source: Haver Analytics
potential growth in the US will become much lower than it was
pre-GFC. Figure 84: China Debt Ratios- Yet to See Deleveraging
250% China Debt to GDP Ratio, % 236.4% 238.5%
With the structural growth challenges confronting many DM, 221.3%
21.8% 22.7%
the export-led growth models employed by many Emerging 197.9% 197.8%
20.1%
Markets have been brought into question. This has been a 200% 182.5% 18.7% 18.8% 60.3% 62.1%
particular challenge for the East Asian economies, such as 155.3%
16.2% 57.7%
China, Korea, Taiwan, Singapore and Malaysia. Attempts to 150% 11.9% 40.1%
53.3% 53.1%
stimulate domestic demand has led to increases in debt levels 34.9%
and elevated property prices. In particular, in China, 100% 99.0%

106.3% 105.9%
79.5% 80.0%
investment-led growth has raised concerns about overcapacity, 71.9%
82.6%
high debt levels and banking system stresses. 50%

25.0% 25.3% 24.5% 25.9% 29.0% 28.4%
15.8%
Geopolitical risks appear to be on the rise, as the post-Cold War
20.8% 21.6% 20.6% 18.9% 18.6% 19.1% 19.4%
period dominated by a single Superpower in the US draws to a 0%
close. The US withdrawal from the Middle-East after a decade 2008 2009 2010 2011 2012 1H13 2H13
Household Small Business Mid/large Corporate
or more of involvement in Afghanistan and Iraq is leaving a Local Government Central Government
power vacuum exaggerated by the impact of the Arab Spring. Source: WIND, CEIC, Leasing Association, ChinaBond.com, Morgan
The rise of China and its territorial claims in the East and South Stanley Research
China Seas is impacting Asia. The Russia-Ukraine instability
adds a further dimension to geopolitical risk.
In cyclical terms the major challenge facing DM is its exit x over-exposure to Australias reform fatigued economy,
strategy from super-accommodative monetary policy. Central which is likely to lead to deteriorating relative economic
bank balance sheets are at record levels (Figure 83), and at performance;
levels as a share of GDP that have not been seen since WW2.
x a lack of diversification;
The US Feds QE3 Tapering is an early example of such an exit
strategy. Beyond QE3, however, the Fed needs to manage both x a lack of exposure to new growth opportunities by
the normalisation of interest rates and of its balance sheet. That geography and industry; and
said, the Fed is currently not at risk of falling behind the
curve, with market rate expectations more dovish than the x over-exposure to political paralysis in Australia.
Summary Economic Projections provided by the Fed. Figure 85: The Morgan Stanley Wealth Management
Furthermore, policy normalisation is far from a global trend, Australia Asset Allocation Process
with both the ECB and Bank of Japan moving or likely to move
to be even more accommodative.
While inflation has generally continued to surprise on the
downside, the unprecedented monetary stimulus from Central
Banks since the GFC means that this remains a risk. To-date,
the substantial excess capacity in labour markets- the US has
just recovered the jobs lost in the GFC- has contained labour
costs, and kept inflation at low levels. Weakness in commodity
prices has reinforced the disinflationary trends. Indeed,
deflationary risks prompted the most recent policy initiatives
from the ECB.
China hardlanding fears appear to be easing, as low profile
policy easing appears to be gaining some traction in the key
economic indicators. Steps to improve regulation of the shadow
banking system and a cooling of the property market have
further reduced risks. Chinas improving export performance
(underlying exports are up 8.4%YoY), low inflation (ex-Food
CPI of 1.7%YoY), moderate levels of Government debt and
strong economic fundamentals provide it with significant
flexibility to meet its growth targets. Nonetheless, it is yet to
deleverage in a meaningful way (Figure 84).
Risks in the Fragile Five Emerging Markets of Brazil, India,
Indonesia, Turkey and South Africa have also receded
somewhat, a reflection of currency depreciation and monetary
tightening leading to reduced imbalances. Elections in India,
Indonesia and South Africa have also reduced uncertainty.
Managing the Risks
Beyond continual analysis of the risks, we believe it is important
to have a strong investment process to effectively manage
investment risk. Morgan Stanley Wealth Management employs
a thorough Asset Allocation process, with an in-depth Strategic
Asset Allocation process augmented by regular updates to our
Tactical Asset Allocation, including International Equities and
the currency (Figure 85).
Doing Nothing is Also a Risk
While there are undoubtedly risks associated with international
equities, there are also risks from remaining with a strong home
bias. As noted earlier, the average Australian household has
c.97% of their assets in Australia. This has many drawbacks,
including:
x a lack of exposure to an overvalued Australian Dollar;
Part 5: Implementation Exchange Traded Funds: an ETF is a portfolio of securities (a

fund) that can be readily traded on the Australian Securities
International exposures may be achieved in four ways:
Exchange. ETFs can be established to track country indices,
1. Directly, for sophisticated investors on Morgan Stanleys particular sectors, asset classes, or targeted investment strategies
Private Wealth Management (PWM) platform; (eg: income). ETFs are passively managed, but amongst their
advantages are the lower fees (versus managed funds), and a
2. Exchange Traded Funds (ETFs); higher degree of liquidity than unlisted managed funds.
3. Listed Investment Companies (LICs); and Listed Investment Companies: are companies which manage a
4. Managed Funds. portfolio of assets and, like ETFs, are listed and can be traded on
the ASX. Some LICs will invest in international equities.
The PWM platform is available for Wholesale Clients (within These can be ideal for an investor with interest in more active
the meaning of the Australian Corporations Act 2001 (Cth)). management of international equity exposures. Some of these
The platform provides clients with direct access to more than 40 LICs also manage the currency actively.
equity markets around the world, as well as the ability to trade in
all assets classes, such as Equities, Fixed Income, Managed Managed Funds: are unlisted investment vehicles which pool
Funds, Alternative Investments, Structured Products, investor funds together to pursue a particular investment style
Currencies, Commodities and Credit Markets. Clients of the and focus. While they are not as liquid as LICs and ETFs, they
PWM Platform can also hedge their portfolios through Options, are actively managed by the fund manager. As with LICs,
Swaps and FX Forwards (Figure 87). You may also use Margin manager selection is an important part of the investment
Lending or Rehypothecation to gain leverage. decision.
To learn more about the PWM Platform, what is available on the To assist in determining investment opportunities
platform, and how it may help manage your Investments, please internationally, Morgan Stanley has a highly ranked Research
contact your Financial Adviser. service that provides research in each of the major regions, and
on over 3,000 companies (Figure 86). In addition to company
For those for whom the PWM platform is unsuitable, research, Morgan Stanley also offers economic insights and
international exposure can also be gained by using ETFs, Listed research targeted at industries, themes, commodities, asset
Investment Companies, and Managed Funds that are available in allocation, and model portfolios.
Australia.
Figure 86: Morgan Stanley Research A Global Presence Figure 87: PWM Offers Risk Management Strategies
North America Europe Asia Pacific Alternative Assets
Volatility exposure
917 Stocks 700 Stocks 892 Stocks Real estate risk
management
Custom hedge fund
exposure
Interest Rates
Interest rate hedging
Cross-currency hedging
Yield enhancement
Commodity Currencies
Hedging and Hedging solutions
investment solutions Tactical investment
Bespoke basket execution
exposure Access
Japan
362 Stocks
Credit
Credit default swaps
Latin America and options
Equity Credit linked notes
Risk management
164 Stocks Portfolio hedging Alternative sale
Single stock hedging strategies
and monetisation Equity swaps
Yield enhancement Structural alpha
Research Coverage over 3,000 stocks. Physical presence in 21 countries
Source: MS Research as of 27 January 2014 Source: Morgan Stanley
Glocal STEP: The Glocal model portfolio is a diversified

International Equities portfolio of 20 positions. The Glocal concept is to think
DIRECT ACCESS VIA THE PWM PLATFORM globally and invest locally by identifying US-based companies
with leading operating positions throughout the world that
For international equities, Wholesale Investors may wish to typically derive at least 20% of their revenue (occasionally as
implement their exposure by investing directly into companies high as 100%) and profits outside of the United States.
using the PWM platform.
Stocks added to the Glocal STEP must meet the following
For assistance in the determining what to invest in, Morgan criteria: (1) Stocks must be rated Overweight or Equal-weight
Stanley provides ratings on over 3,000 individual companies by Morgan Stanley; (2) All additions and deletions to the STEP
globally. In addition, both Morgan Stanley and Morgan Stanley will be reviewed by the STEP Committee for fundamental and
Wealth Management globally operate equity model portfolios sector applicability; (3) The portfolio emphasises large-
which can serve as guides to building a portfolio. capitalisation, liquid stocks, with market capitalisation typically
MSWM International STEPs at least US$5 billion; and (4) If a stock is downgraded to
Underweight or research coverage is temporarily discontinued
The STEP portfolios are model portfolios maintained by by Morgan Stanley, it may be retained in the portfolio at the
MSWM. They are updated regularly and range from Committees discretion. The yield on the portfolio is typically
international portfolios, such as the Core Global to US equity close to the US market average- currently it is 2.1%- while
specific portfolios such as the Glocal (US companies with a turnover is usually low- in 2013 turnover was just 38%.
global reach), US Core and Dividend STEP portfolios. All
STEPs have outperformed the relevant benchmark since Core Global Diversified Global Exposure: The Core Global
inception (Figure 88). STEP provides direct exposure to individual companies
throughout the world. The sector and geographic weightings in
Figure 88: STEP Performance as of 30 June 2014 this portfolio incorporates the views of Morgan Stanleys
strategists, economists and analysts globally.
The Core Global has more ability than other STEPs to
incorporate small- and mid-cap stocks, as well as earlier-stage
growth companies, and as mentioned, draws heavily from stock
ideas outside North America. Core Global may utilise Exchange
Traded Funds and Closed End Funds to obtain a presence in
specific geographies and/or sectors that are difficult to access
through individual equities. The STEP currently has 34 stocks
in the portfolio, an average yield of 2.3%, and as of 2013, a
portfolio turnover of 30%.
Other STEPs: Other international portfolios are focused on the
Source: MSWM Research, Bloomberg. Annualised since inception p.a. US specifically, and include the US Core and Dividend
Results shown represent total return (includes dividends) and exclude
portfolios. Investors may enquire with their Financial Advisers
brokerage commissions. Past performance is no guarantee of future results.
for details on all STEP models holdings, performance and latest
Figure 89: STEP Turnover in 2013 strategy.
Morgan Stanley Equity Strategy Portfolios
Morgan Stanley also has equity strategy teams in the key global
regions- the US, Europe (including the UK), Japan, Asia ex-
Japan and Emerging markets- that provide equity model
portfolios or focus lists which can assist in making investment
decisions.
EXCHANGE TRADED FUNDS LICs with solid performance over the medium- to long-term
include PMC (Platinum Capital Ltd), HHV (Hunter Hall Value),
Figure 90 provides a list of International ETFs available to an
TGG (Templeton Global Growth) and the Magellan Flagship
Australian investor. With the exception of one product, the
Fund (MFF).
current suite of ETFs is unhedged. Investors who wish to take a
currency view can do so by buying the SPDR S&P World ex- MANAGED FUNDS
Australia Hedged ETF.
An investor may also invest in an unlisted managed fund to gain
LISTED INVESTMENT COMPANIES exposure to International Equities. Figure 91 lists the managed
funds in our approved universe for international equities.
Some LICs listed on the ASX invest in international equities.
These can be ideal for an investor with interest in more active
international equity exposure. Some of these LICs also manage
the currency actively.
Figure 90: International Equity ETF Universe

3M 6M 1Y
Market Operational
Name Benchmark Code ICR Performance Performance Performance
Cap (m) Structure
(%) (%) (%)
Global
iShares Global 100 S&P Global 100 IOO 0.40% 895 Full Replication 1.8 -1.0 16.7
Vanguard All-World ex US Shares FTSE All World ex-US VEU 0.25% 243 Full Replication 2.5 -0.7 17.2
SPDR S&P World ex Australia Fund S&P Developed Ex-AU Large-Mid TR AUD WXOZ 0.42% 49 Optimised Sampling 3.3 0.5 20.0
SPDR S&P Global Dividend Fund S&P Global Dividend Aristocrats Index WDIV 0.50% 15 Full Replication 4.2 3.9 -
Global Hedged
SPDR S&P World ex Australia (Hedged) Fund S&P Developed Ex-AU Large-Mid TR AUD WXHG 0.48% 15 Optimised Sampling 5.2 6.2 0.0
Regional
iShares MSCI EAFE MSCI EAFE IVE 0.35% 42828 Full Replication 2.2 -0.7 19.6
iShares MSCI Emerging Markets MSCI Emerging Markets IEM 0.72% 20331 Full Replication 4.7 0.3 10.4
Vanguard FTSE Emerging Markets FTSE Emerging Index VGE 0.48% 9 Full Replication 5.1 0.3 -
iShares MSCI BRIC Index Fund MSCI BRIC IBK 0.72% 158 Full Replication 5.8 -1.1 11.1
United States
iShares S&P500 S&P 500 IVV 0.09% 24728 Full Replication 3.3 1.5 20.7
iShares Russell 2000 Russell 2000 (US Mid/Small) IRU 0.28% 17950 Full Replication 0.2 -2.2 19.9
iShares Midcap 400 S&P Midcap 400 IJH 0.22% 8600 Full Replication 2.4 1.9 21.4
iShares S&P Smallcap 600 S&P Smallcap 600 IJR 0.20% 8309 Full Replication 0.2 -2.2 21.7
Vanguard US Total Market Shares MSCI US Broad Market VTS 0.07% 329 Full Replication 3.0 1.4 21.3
Europe
iShares S&P Europe 350 S&P Europe 350 IEU 0.60% 2583 Full Replication 1.6 0.2 25.5
Asia
iShares MSCI Japan MSCI Japan IJP 0.56% 10727 Full Replication 4.5 -4.7 6.1
iShares FTSE Xinhua China 25 FTSE/Xinhua China 25 IZZ 0.72% 5631 Full Replication 3.8 -5.8 11.9
iShares MSCI South Korea MSCI South Korea IKO 0.65% 3737 Full Replication 4.5 -2.4 20.2
iShares MSCI Taiwan MSCI Taiwan ITW 0.82% 3236 Full Replication 8.1 5.3 15.5
iShares MSCI Hong Kong MSCI Hong Kong IHK 0.55% 2779 Full Replication 6.3 -0.9 14.7
iShares MSCI Singapore MSCI Singapore ISG 0.55% 2158 Full Replication 3.5 -0.8 6.5
iShares S&P Asia 50 Index Fund S&P Asia 50 IAA 0.52% 92 Full Replication 4.7 -2.1 11.8
Sector
iShares S&P Global Healthcare S&P Global Healthcare IXJ 0.48% 1331 Full Replication 2.8 4.8 24.4
iShares S&P Global Consumer Staples S&P Global Consumer Staples IXI 0.48% 452 Full Replication 3.4 0.2 11.8
iShares S&P Global Telecommunications S&P Global Telecom IXP 0.48% 314 Full Replication 1.9 -3.5 15.2
Source: MSWM Research, Morningstar. Returns as at 30 June 2014.
Figure 91: International Equities Managed Fund Recommended Universe

Morningstar 3 Month 6 Month 1 Year 3 Year 5 Year 10 Year
Name APIR Zenith Rating ICR (%) FuM (m) Perf Fee
Rating Return Return Return Return (p.a.) Return (p.a.) Return (p.a.)
Large Core
BlackRock Indexed Int Equity Fund BGL0106AU Bronze Recommended 0.20 166 No 3.0% 0.6% 20.3% 16.9% 11.5% 3.9%
Dimensional Global Large Company Trust DFA0105AU Bronze Approved 0.35 102 No 3.1% 0.4% 20.6% 16.8% 11.6% 3.9%
BT Core Gbl Share WS RFA0821AU Bronze Recommended 0.97 185 No 2.2% 0.8% 20.3% 17.3% 12.3% 3.9%
BT Core Hedged Global Share WS RFA0031AU Bronze Recommended 0.97 26 No 4.3% 6.8% 24.3% 16.1% 17.8% 8.1%
Arrowstreet Global Equity MAQ0464AU Silver Highly Recommended 1.28 394 No 4.2% 2.8% 25.9% 18.8% 13.2% 0.0%
Arrowstreet Global Equity Hedged MAQ0079AU Silver Highly Recommended 1.28 407 No 6.1% 8.8% 30.4% 17.1% 19.4% 10.8%
Altrinsic Global Equities Trust ANT0005AU Bronze Recommended 1.25 155 No 2.4% -1.1% 14.6% - - -
Magellan Global MGE0001AU Silver Highly Recommended 1.35 5551 Yes 0.0% -3.0% 11.8% 22.7% 16.6% 0.0%
Vanguard International Shares Index VAN0003AU Bronze Recommended 0.18 7190 No 3.1% 0.8% 20.7% 16.9% 11.5% 3.9%
Large Value
Dimensional Global Core Equity Trust DFA0004AU Bronze Recommended 0.39 962 No 2.7% 0.8% 21.6% 16.4% 12.1% -
Dimensional Global Value Trust DFA0102AU Bronze Recommended 0.46 627 No 2.6% 0.6% 22.8% 16.6% 12.3% 4.5%
Platinum Unhedged PLA0006AU Silver Recommended 1.54 292 Yes 3.1% 2.5% 22.2% 16.0% 13.1% -
Platinum International PLA0002AU Gold Highly Recommended 1.54 9524 Yes 2.2% -1.0% 17.4% 14.7% 9.4% 7.5%
Aberdeen International Equity EQI0015AU Silver Recommended 0.98 465 No 3.4% 2.6% 16.4% 14.7% 11.4% 7.4%
Aberdeen Fully Hedged Internat'l Equity CSA0135AU Silver Recommended 0.99 48 No 5.2% 8.4% 19.4% 13.5% 16.9% 7.6%
Schroder Global Active Value SCH0030AU Bronze Recommended 0.98 1259 No 2.8% 1.3% 21.4% 14.3% 11.5% -
Schroder Global Active Value Hedged SCH0032AU Bronze Recommended 0.98 166 No 4.6% 6.7% 24.2% 12.8% 16.7% -
Large Growth
T. Rowe Price Global Equity ETL0071AU Bronze Recommended 1.20 738 No 4.0% 2.1% 20.4% 14.3% 9.5% -
Capital International Global Equity WHT0018AU Bronze Recommended 0.96 297 No 2.2% -1.6% 17.7% 15.8% 10.3% -
Generation Wholesale Global Share FSF0908AU Bronze Recommended 1.24 93 Yes -0.3% 0.5% 18.2% 16.3% 11.4% -
Franklin Global Growth FRT0009AU Silver Recommended 1.11 15 No 2.0% -2.5% 18.0% 14.2% 11.8% -
Walter Scott Global Equity MAQ0410AU Silver Highly Recommended 1.28 1651 No 2.6% -1.8% 14.2% 15.0% 9.6% -
Walter Scott Global Equity Hedged MAQ0557AU Silver Highly Recommended 1.28 446 No 4.7% 3.9% 18.0% 13.7% 15.0% -
MFS Global Equity Trust MIA0001AU Gold Highly Recommended 0.77 5786 No 2.2% -0.7% 19.4% 18.9% 14.1% 6.6%
MFS Fully Hedged Global Equity Trust ETL0041AU Gold Highly Recommended 0.80 936 No 4.4% 5.3% 22.3% 17.6% 20.0% -
Zurich Investments Gbl Thematic Shr ZUR0061AU Silver Recommended 0.98 1195 Yes 4.0% 0.7% 16.3% 13.6% 7.9% 6.0%
Zurich Investments Hgd Gbl Thematic Shr ZUR0517AU Silver Recommended 0.98 239 Yes 5.7% 6.2% 21.2% 12.8% 13.4% -
Large Income
Grant Samuel Epoch Global Equity Yield GSF0002AU Bronze Recommended 1.25 1214 No 3.7% 3.1% 19.5% 17.6% 12.4% -
Grant Samuel Epoch Global Yld Hedged GSF0001AU Bronze Recommended 1.30 265 No 5.6% 9.1% 21.9% 16.0% 18.6% -
Threadneedle Global Equity Income HFL0032AU Neutral Recommended 1.15 42 No 2.3% -1.2% 14.0% 0.0% 0.0% -
Global Small Cap
BlackRock WS Global Small Cap Fund MAL0133AU Neutral Approved 1.25 240 No 1.3% 0.2% 31.7% 18.2% 15.3% 7.8%
Lazard Global Small Cap Fund LAZ0012AU Neutral 1.12 51 No 4.0% 3.0% 29.2% 21.0% 16.6% 7.1%
Asian Equities
Platinum Asia Fund PLA0004AU Silver Highly Recommended 1.54 4426 Yes 6.2% 2.5% 17.4% 12.2% 8.7% 14.2%
BT Asian Share BTA0054AU Neutral Approved 1.00 191 No 2.4% -5.1% 8.0% 6.3% 7.5% 7.9%
Macquarie Asia New Stars No.1 MAQ0640AU Bronze Recommended 3.56 95 Yes 5.7% 2.7% 15.6% 12.7% - -
Aberdeen Asian Opportunities EQI0028AU Silver Highly Recommended 1.18 599 No 4.3% 2.6% 5.8% 10.1% 10.6% -
TAAM New Asia TGP0006AU Neutral Recommended 1.03 25 Yes 4.3% 1.4% 12.7% 7.7% 5.2% -
GaveKal Asian Opportunities HFL0014AU Neutral Recommended 1.92 28 No 2.3% -4.9% 0.6% 9.0% - -
Emerging Markets
Aberdeen Emerging Opportunities Fund ETL0032AU Silver Highly Recommended 1.50 1167 No 4.8% 2.5% 6.2% 7.7% 10.4% -
Dimensional Emerging Markets Trust DFA0107AU Neutral Recommended 0.71 373 No 5.8% 1.4% 12.8% 2.4% 4.9% 7.9%
Lazard Emerging Markets Equity LAZ0003AU Silver Recommended 1.12 937 No 7.4% 3.4% 14.6% 7.2% 8.6% 12.0%
Schroder Global Emerging Markets SCH0034AU Neutral Recommended 1.40 191 No 4.7% -1.3% 10.0% 5.0% 5.4% -
Sector
CFS Wholesale Global Resources FSF0038AU Silver Recommended 1.18 489 No 6.5% 6.4% 26.3% -6.5% 2.2% 7.3%
IFP Global Franchise MAQ0404AU Silver Highly Recommended 1.38 1273 No 3.8% 1.0% 16.2% 19.1% 15.6% -
IFP Global Franchise Fund (Hedged) MAQ0631AU Silver Highly Recommended 1.38 65 No 5.7% 6.8% 17.9% 17.3% 0.0% -
Platinum International Brands PLA0100AU Silver Highly Recommended 1.54 1229 Yes -0.4% -3.6% 11.1% 11.9% 15.5% 11.8%
Source: MSWM Research, Zenith, Morningstar. Returns as of 30 June 2014.
Listed Property underlying diversification benefit of listed property is not

reduced significantly without access to global REITs or
Figure 92 provides a list of ETF and Managed Fund
infrastructure.
implementation options in the Listed Property sector. There is
currently only one global REIT ETF in Australia, launched in
November 2013
Global listed infrastructure is also an option (see Alternatives
section for recommended implantation). We believe the
Figure 92: Listed Property ETFs and International REIT Managed Funds
3M 6M 1Y
Operational
Name Benchmark Code ICR Market Cap (m) Performance Performance Performance
Structure
(%) (%) (%)
GREIT
SPDR Dow Jones Global Real Estate Fund DJ Gbl Select RESI TR USD DJRE 0.50% 11.7 Full Replication 5.6 7.6 -
Morningstar 3 Month 6 Month 1 Year 3 Year

Rating Return Return Return Return (p.a.)
Managed Funds
UBS Clarion Global Property Securities HML0016AU Gold Recommended 0.90 187 No 7.9% 15.1% 16.0% 12.3%
Resolution Capital Global Property Securities Fund WHT0015AU Silver Highly Recommended 0.88 55 Yes 6.9% 13.6% 16.5% 13.2%
Source: MSWM Research, Zenith, Morningstar, Factset. Returns as of 30 June 2014
Fixed Income
PWM clients can invest directly into bonds, though the size of approach (Figure 93). While there are a number of Australian
capital required in order to create a diversified bond portfolio Fixed Income ETFs, an International equivalent is yet to be
can be large. Other clients should pursue a managed fund launched.
Figure 93: Fixed Income Managed Fund Recommended Universe

Morningstar 3 Month 6 Month 1 Year 3 Year 5 Year 10 Year
Rating Return Return Return Return (p.a.) Return (p.a.) Return (p.a.)
Broad Fixed Income

Macquarie Diversified Fixed Interest MAQ0274AU Silver Recommended 0.64 1028 No 2.5% 3.6% 5.0% 6.1% 7.4% 6.3%
Franklin Templeton Multisector Bond Fund FRT0011AU Silver Recommended 0.91 182 No 3.3% 4.4% 9.8% 9.6% - -
PIMCO EQT Diversified Fixed Interest ETL0016AU Gold Recommended 0.49 1240 Yes 3.1% 5.5% 7.2% 7.5% 9.9% 7.5%
Vanguard Diversified Bond Index Fund VAN0042AU Silver Recommended 0.34 306 No 2.7% 5.0% 6.8% 7.4% - -
International Bonds
Advance Int Fix Intr Multi-Blend W ADV0067AU Bronze Recommended 0.65 810 No 2.6% 5.0% 7.7% 7.9% 9.3% 8.3%
Dimensional Five-Year Diversified F/I DFA0108AU Bronze Recommended 0.28 1153 No 1.8% 3.0% 5.1% 6.0% 7.3% 6.7%
Vanguard International Fixed Interest Index (Hgd) VAN0103AU Bronze Recommended 0.26 1558 No 2.2% 5.0% 6.9% 7.4% 7.4% 7.3%
PIMCO EQT Global Bond Fund ETL0018AU Gold Highly Recommended 0.47 3109 No 3.1% 6.7% 8.6% 8.0% 11.5% 8.3%
Credit
Macquarie Income Opportunities Fund MAQ0277AU Silver Recommended 0.50 2171 No 1.3% 2.5% 5.0% 5.6% 7.3% 5.9%
PM Capital Enhanced Yield PMC0103AU Bronze Recommended 1.50 398 Yes 1.4% 2.5% 5.5% 5.3% 5.9% 5.8%
Schroder Credit Securities SCH0103AU Bronze Recommended 0.75 650 No 1.5% 2.8% 5.7% 6.0% 8.7% 5.6%
Vanguard Intl Credit Secs Index Hgd VAN0106AU Bronze Recommended 0.34 538 No 2.7% 5.8% 8.5% 8.2% 9.1% 7.6%
Bentham Global Income Fund CSA0038AU Silver Recommended 0.77 1051 No 2.2% 4.4% 10.7% 10.3% 16.9% 8.4%
Short-Duration / Enhanced Cash
Kapstream Wholesale Absolute Return Income HOW0052AU Bronze Recommended 0.70 974 Yes 1.3% 2.7% 5.2% 5.7% 5.9% 0.0%
CFS Wholesale Enhanced Yield FSF0694AU Neutral Approved 0.52 89 Yes 0.5% 1.7% 5.8% 5.0% 6.9% 0.0%
Dimensional Short Term Fixed Interest DFA0100AU Neutral Recommended 0.19 475 No 0.7% 1.3% 2.8% 3.7% 4.2% 5.1%
Alternative Assets
A commodities investment can be implemented via managed major precious metals, crude oil and agriculture, and a
funds or via ETFs. Direct investment in commodities is diversified basket of commodities including industrial metals
inadvisable except for precious metals, due to problems with and livestock.
storage and transportation, as well as the perishable nature of
The approved managed fund universe (Figure 95) includes one
some commodities.
fund (Ascalon) which invests in commodity futures and employs
We recommend ETFs for direct exposure to commodities a managed futures model, as well as two funds which invest in
(Figure 94). Currently, the commodities available include the commodity producing equities. We note that with the latter two,
one will also inevitably be taking on operational and equity risk.
Figure 94: Commodities ETF Universe

3M 6M 1Y
Market Operational
Name Benchmark Code ICR Performance Performance Performance
Cap (m) Structure
(%) (%) (%)
Diversifed Commodities
BetaShares Commodities (Hedged) S&P GSCI Light Energy ER QCB 0.69% 7 Unfunded Swap -0.9 5.1 5.4
Precious Metals
ETFS Physical Gold Gold GOLD 0.40% 435 Physical ETC -0.1 3.5 6.6
ETFS Physical Silver Silver ETPMAG 0.49% 48 Physical ETC 2.5 1.2 6.8
BetaShares Gold Bullion (Hedged) Gold (Hedged) QAU 0.39% 24 Full Replication 1.8 10.2 10.8
ETFS Physical Precious Metals Basket of Precious Metals ETPMPM 0.43% 5 Physical ETC 1.8 4.2 9.5
ETFS Physical Platinum Platinum ETPMPT 0.49% 4 Physical ETC 2.4 3.1 8.4
ETFS Physical Palladium Palladium ETPMPD 0.49% 1 Physical ETC 6.4 12.2 26.7
Energy Commodities
BetaShares Crude Oil ETF (Hedged) S&P GSCI Crude Oil ER OOO 0.69% 3 Unfunded Swap 5.1 9.4 13.5
Agricultural Commodities
BetaShares Agriculture ETF (Hedged) S&P GSCI Agriculture Enh ER QAG 0.69% 3 Unfunded Swap -9.7 2.1 -7.3
Industrial Metals
ETFS Industrial Metals Dow Jones-UBS Industrial Metals ETPIND 0.49% 0 Funded Swap 6.3 -2.3 4.1
ETFS Copper Dow Jones-UBS Copper ETPCOP 0.49% 1 Funded Swap 4.2 -10.5 0.7
Market Short
BetaShares Aus Eq Bear Hedge Fund Short S&P/ASX200 Index BEAR 1.19% 53 Unfunded Swap 0.3 -0.7 -11.8
Source: MSWM Research, ASX, IRESS, Factset, Morningstar. Returns as at 30 June 2014.
Figure 95: Alternatives Managed Fund Recommended Universe

Morningstar 3 Month 6 Month 1 Year 3 Year 5 Year
Name APIR Zenith Rating ICR FuM (m) Perf Fee
Rating Return Return Return Return (p.a.) Return (p.a.)
Commodities
Ascalon H3 Commodities Fund AMR0001AU Recommended 1.44 9 Yes -1.8% 0.6% -1.4% -8.3% -3.3%
Credit Suisse Enhanced Commodity Fund CSA0063AU Recommended 0.66 353 No 3.4% 6.2% 12.4% 2.2% 5.5%
Alternative Beta - Diversified
Advance Alternative Strategies Multi-Blend Fund ADV0159AU Approved 1.14 181 Yes 1.1% 2.2% 5.4% - -
AQR DELTA PER0554AU Bronze Recommended 1.30 66 Yes 0.9% 0.4% 3.2% 3.8% 0.0%
Ironbark Global Diversified Alternatives DEU0109AU Approved 1.10 97 Yes 1.7% 2.1% 7.7% 2.1% 2.8%
LHP Diversified Investments HFL0104AU Approved 1.44 111 No 0.6% 7.6% 13.8% 8.6% 9.7%
Select Alternatives Portfolio SLT0005AU Neutral 1.28 34 Yes -1.0% 1.7% 0.6% 0.3% 3.9%
Alternative Beta - Global Macro
BlackRock Scientific Global Markets BGL0045AU Bronze Recommended 1.03 76 Yes 1.4% -4.6% -1.3% 0.6% 3.9%
GMO Systematic Global Macro Trust GMO0006AU Highly Recommended 2.34 991 Yes -0.3% 2.7% 7.3% 9.5% 9.9%
Alternative Beta - Equity Hedge
K2 Asian Absolute Return KAM0100AU Neutral Recommended 3.44 98 Yes -2.1% -6.5% 7.4% 4.8% 6.4%
K2 Australian Absolute Return KAM0101AU Neutral Recommended 5.00 405 Yes -1.0% 0.5% 12.5% 8.8% 10.4%
K2 Select International Absolute Return ETL0046AU Neutral Recommended 5.48 232 Yes -3.2% -8.2% 7.7% 7.4% 9.6%
WaveStone WS Aus Equity Long/Short HOW0053AU Recommended 3.76 171 Yes -0.9% 2.7% 15.0% 11.9% 0.0%
Aurora Fortitude Absolute Return Fund AFM0005AU Recommended 2.17 174 Yes -0.1% 1.1% 4.6% 5.4% 4.7%
Bennelong Long Short Equity Fund BFL0005AU Highly Recommended 4.92 362 Yes -6.1% -5.9% 3.2% 9.4% 14.6%
Perpetual W Share Plus L/S PER0072AU Highly Recommended 1.40 438 Yes 3.6% 5.0% 22.2% 18.0% 17.4%
BlackRock Australian Eq Absolute Return MAL0079AU Highly Recommended 1.87 100 Yes -4.9% -2.4% 0.7% - -
Acadian Wholesale Quant Yield FSF0797AU Neutral Recommended 0.90 18 No 0.1% 1.4% 3.0% 4.3% 4.7%
LHP Global Long/Short HFL0108AU Recommended 2.72 138 Yes 1.5% 2.7% 12.2% 10.0% 9.1%
Alternative Beta - Event Driven
Pengana Asia Special Events Fund PCL0004AU Recommended 1.18 65 Yes 0.8% 2.0% 8.0% 7.1% 0.0%
Managed Futures
Aspect Diversified Futures FSF1086AU Bronze Recommended 1.61 102 Yes 6.6% 1.3% -0.6% 1.6% 0.0%
Winton Global Alpha MAQ0482AU Bronze Recommended 2.26 1029 Yes 3.7% 3.4% 8.8% 7.5% 8.4%
Man AHL Alpha MAN0002AU Recommended 2.19 29 Yes 9.1% 8.0% 10.2% 4.7% 0.0%
AQR Wholesale Managed Futures PER0634AU Bronze Recommended 1.30 29 Yes 3.9% -5.5% 3.7% - -
Direct Property
AMP Capital Core Property Fund AMP1015AU Recommended 1.12 507 No 5.3% 8.6% 10.5% 10.4% 12.1%
Private Equity
Partners Group Global Value Fund (AUD) ETL0277AU Recommended 1.75 14.0 No 1.3% 6.3% 14.1% - -
MultiSector
Schroder Real Return Fund SCH0047AU Silver Recommended 0.90 634 1.5% 2.6% 8.0% 8.0% 0.0%
Global Infrastructure
Lazard Global Listed Infrastructure LAZ0014AU Bronze Recommended 0.98 918 No 6.5% 15.4% 33.2% 20.6% 20.8%
Macquarie International Infrastructure Securities MAQ0432AU Neutral Approved 1.02 556 No 7.0% 12.7% 23.6% 15.9% 16.5%
Magellan Infrastructure MGE0002AU Silver Highly Recommended 1.63 651 Yes 4.5% 12.4% 22.0% 15.6% 18.7%
RARE Infrastructure Value TGP0008AU Silver Highly Recommended 1.32 1243 Yes 5.2% 9.5% 18.5% 13.0% 16.3%
RARE Infrastructure Value Unhedged TGP0034AU Silver Highly Recommended 1.27 488 Yes 3.8% 4.8% 16.0% - -
Appendix
Figure 96: Long-Term Real Annual Returns for Different

Asset Classes
International Australian
Australian International Int FI AUD USD
Real Returns Equities Fixed Inflation
Equities Equities (Lcl) Hedged Spot FX
(AUD) Income
1970 -21.9% -5.9% -0.3% 3.4%

1971 -12.8% 5.3% 6.6% 6.1%
1972 8.8% 10.1% 7.3% 6.0%
1973 -32.9% -34.8% 16.8% 9.1%
1974 -34.2% -26.4% -10.8% 15.4%
1975 36.5% 19.9% -5.1% 15.2%
1976 -8.4% 16.1% -13.5% 13.3%
1977 -5.0% -14.7% 5.7% 12.3%
1978 12.1% 7.0% 9.6% -0.2% 8.0%
1979 37.0% 5.1% -10.3% -3.8% 9.1%
1980 35.2% 6.5% -8.2% 6.7% 10.1%
1981 -20.5% -8.4% -0.9% -4.5% 9.5%
1982 -22.6% 14.2% 11.4% -12.8% 11.4%
1983 51.6% 20.2% 2.6% -8.8% 10.0%
1984 -6.0% 10.0% 7.8% -8.0% 4.0%
1985 35.0% 60.0% 1.3% -17.3% 6.7%
1986 39.6% 33.5% 9.1% 15.2% -2.5% 9.1%
1987 -15.1% -1.4% 9.3% 4.6% 8.8% 8.5%
1988 9.7% -3.1% 18.3% 1.8% 5.9% 18.3% 7.4%
1989 10.3% 18.6% 17.3% 7.4% 10.9% -7.7% 6.4%
1990 -22.4% -20.1% -25.7% 12.1% 7.4% -2.4% 6.3%
1991 28.5% 14.8% 11.6% 19.4% 13.8% -1.1% 4.5%
1992 -5.5% 1.7% -3.4% 7.4% 7.1% -9.5% 2.8%
1993 36.7% 20.8% 18.0% 13.2% 10.5% -1.4% 2.8%
1994 -11.0% -10.2% -2.6% -6.9% -4.8% 14.1% 2.4%
1995 16.9% 22.0% 16.2% 14.8% 16.8% -4.1% 3.3%
1996 11.0% 3.2% 13.9% 8.7% 6.3% 6.8% 3.0%
1997 9.3% 39.0% 20.8% 10.1% 8.6% -18.0% 1.9%
1998 6.7% 30.1% 19.2% 7.7% 8.2% -5.9% 1.7%
1999 17.9% 15.8% 26.8% -2.4% -0.9% 6.7% 1.2%
2000 1.1% -1.6% -13.2% 7.9% 7.5% -15.1% 3.9%
2001 5.5% -13.8% -17.8% 1.0% 3.7% -7.9% 4.4%
2002 -11.0% -29.7% -26.4% 5.4% 8.1% 10.0% 3.2%
2003 12.9% -3.3% 22.5% 0.4% 3.8% 33.8% 2.7%
2004 25.1% 7.8% 9.4% 4.9% 6.8% 4.0% 2.0%
2005 18.3% 14.2% 13.5% 3.4% 1.5% -6.4% 2.3%
2006 21.9% 8.8% 13.1% 0.6% 2.8% 7.5% 2.5%
2007 14.9% -5.1% 2.1% 0.8% 3.8% 11.4% 2.7%
2008 -42.7% -27.9% -40.8% 10.4% 4.9% -20.6% 4.1%
2009 36.0% -2.9% 22.9% -0.9% 5.2% 29.0% 2.6%
2010 0.5% -4.7% 8.0% 3.2% 6.3% 14.0% 2.8%
2011 -13.6% -7.7% -7.1% 8.6% 7.8% 0.0% 2.5%
2012 16.3% 11.7% 13.8% 5.4% 7.3% 1.3% 2.2%
2013 16.7% 44.4% 26.7% -0.5% 4.4% -13.8% 2.5%
YTD Jun-14 1.7% -0.4% 4.9% 3.6% 4.4% 5.9% 1.0%
Returns
Since 1970 4.1% 3.7% 3.9% -0.4% 5.7%
Since 1980 6.8% 5.8% 5.0% -0.4% 4.4%
Since 1990 6.1% 2.7% 2.3% 5.5% 6.1% 0.7% 2.9%
Since 2000 5.2% -2.2% -2.0% 3.7% 5.4% 2.6% 2.8%
70's -5.0% -3.5% -0.1% 9.7%

80's 8.7% 13.6% 4.0% -3.3% 8.3%
90's 7.4% 10.3% 8.3% 8.1% 7.1% -1.9% 3.0%
00's 5.6% -6.5% -3.9% 3.3% 4.8% 3.2% 3.0%
2010-Jun 2014 5.2% 10.2% 12.4% 5.7% 8.5% 1.5% 3.1%
Source: Factset, MSWM Research. Shaded areas represent years with
Australian Recessions (2 quarters of negative GDP growth).
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investment strategy august 2014

4 10 Reasons to Go International 31 The Major Risks

Investing Without Borders:

Part 2: Outlook for the Major International Asset Classes ......................................................15

Part 3: Outlook for the Major International Regions.................................................................23

Part 4: The Major Risks..................................................................................................................31

Part 1: 10 Reasons to Go International Figure 4: Australia GDP Growth has Dramatically

Source: ABS, IMF, MSWM Research

What has driven Australias dramatic outperformance, and can it

Source: ABS, MSWM Research

Source: Factset, MSWM Research. Data as of 26 June 2014.

Source: ABS, IMF, MSWM Research

Turning to financial markets, Australia has a 3.2% weight in

Source: RBA, MSWM Research

First, superannuation has been taking a growing share of

Source: Australian National Accounts, 2012, Deloitte Analysis 2013

Source: Factset, MSWM Research. Weights as of July 2014.

A strong argument in favour of international exposure is the

Source: Factset, MSWM Research. Data as of 26 June 2014.

In addition, international investment offers exposure to

Source: IMF, MSWM Research

Looking ahead, Morgan Stanley expects EM growth to

x Social media allows individuals to quickly communicate,

Source: ABS, MSWM Research

The floating of the exchange rate and the abolition of exchange

Source: ABS, RBA, MSWM Research

In our view, this multi-faceted trend toward globalisation should

Source: Factset, RBA, MSWM Research

Looking forward, we contend that Australias period of

Source: IMF, ABS, MSWM Research

In the next section, where we analyse the prospects for future

International DM Sovereign 0.40 0.52 -0.10 0.17

International DM IG Credit 0.18 0.03 0.33 0.32

International Equity Return (AUD) 0.10 0.06 0.38 0.28

GREIT 0.18 0.15 0.51 0.51

Source: MSWM Research, Factset. Green shading shows lower correlations.

Morgan Stanley Wealth Management offers suggested Strategic

Source: MSWM Research, Factset, MSCI World PE (IBES)

From a cyclically adjusted perspective, valuations are not

Source: MSWM Research, Factset, MSCI World PE using MSCI

From an unhedged perspective, we expect the AUD to fall

Figure 42: Australias Real Effective Exchange Rate

Source: MSWM Research, RBA

The second building-block approach to expected returns for

Source: Datastream, MSWM Research. Total Return Indices, re-based to

Government Bond equilibrium yield assumption is just above 3.0%, obtained by

International currency exposures via international bonds are

Government Bond Corporate Bond

Minimal Low High

In determining long-term returns within International DM

International Credit Another way to look at corporate credit is in relation to the

Short-term Investment Grade

High Yield Bond

Investors can also invest in the sovereign credit of less

Because of credit risk, corporate bonds need to pay a premium

Source: MSWM Research, Factset

Source: MSWM Research, Factset

benefits that are higher than what is achievable in traditional

Implied Volatility (3M ATM) Historical Volatility (60D Parkinson)

Source: MSWM Research, Bloomberg. ASX200

2) Carry Risk Premium

Source: IRESS, MSWM Research

Key Catalysts and Risks to Watch:

investment strategy august 2014