Morgan Stanley Smith Barney: Finding returns in 2012

The following is a portion of the most recent research bulletin of the Morgan Stanley Smith Barney Global Investment Committee. To read the full version of the bulletin, released yesterday, click here here.

The Global Investment Committee (GIC) believes policy disarray on both sides of the Atlantic has tipped the Euro Zone into a recession, with the US soon to follow. Still, while regional economies are linked by trade and finance more than ever, the global economy will likely avoid recession due to emerging market (EM) growth. Despite the headwinds to EM exports that may be caused by sluggish outlooks for the developed market (DM) economies, both Morgan Stanley and Citi economists expect GDP growth in EM countries to exceed 5% in 2012.

Given a slower-than-desired growth forecast, the GIC enters 2012 with a more cautious stance toward risk assets than in recent years. Still there are always investment opportunities that offer attractive valuation, portfolio diversification, income generation and other attributes fitting to the times.

The areas of opportunity that interest us in 2012 are varied. Five of our ideas target high-quality income generation in a low interest rate environment: dividend aristocrats, investment-grade credit, short-duration bonds, prerefunded municipal securities and master limited partnerships. Beyond those, emerging market equities also offer higher dividend yields than their DM peers. Our preference for the emerging markets continues with “global gorillas,” or DM companies with considerable business exposure and growth potential in the emerging markets. We also highlight an important secular theme: water—a finite resource that is not always available where it is needed, especially in the fast-growing urban centers of EM countries. Finally, we believe that good risk management starts with portfolio diversification. Thus, we have included managed futures, which, as an asset class, have low correlations with global stocks and bonds.

2011 PERFORMANCE REVIEW. The past year was a challenging one for equities, and our 2011 equity-related ideas were not spared. In a period in which global equities, as measured by the MSCI All Country World Index, returned -4.3%, our equity ideas—resource-rich countries, emerging market equities, global gorillas, water and alternative energy—all posted negative returns. Global real estate investment trusts posted a return slightly below that of global equities. The best performing idea for 2011 was TIPS and WIPS, which represent US and non-US inflation-linked securities—and ended up 11.7% on a total return basis. High yield bonds came in second best, with a 7.2% total return. All returns are reported as of Dec. 30, in US dollars.

US LARGE-CAP GROWTH. This selection incorporates our preference for US equities in terms of market capitalization and style. Large-cap stocks tend to be more defensive than mid- and small-cap stocks and typically outperform them in adverse market conditions. Moreover, from a valuation perspective, large-cap stocks appear historically cheap relative to mid- and small-cap stocks.

A similar line of reasoning augurs well for growth stocks over value stocks. By historical standards, value stocks appear expensive relative to growth stocks.

The ratio of the price/earnings (P/E) multiple of the Russell 1000 Value Index to that of the Russell 1000 Growth Index, our benchmark, is nearly 0.8 versus a three-decade average of 0.7, indicating that growth remains cheap relative to value (see Chart 1).

Furthermore, during the periods of declining corporate earnings that accompany recessionary episodes, growth stocks—companies that can deliver relatively stable earnings growth regardless of the economic backdrop or those that can generate above-average earnings growth—typically perform better.

DIVIDEND ARISTOCRATS. This investment is defined by our benchmark, the S&P 500 Dividend Aristocrats Index. This index comprises 42 large-cap, blue-chip companies that have raised dividend payouts annually for at least 25 years. Companies in the index have solid franchises in the health care, consumer products and materials sectors. In a period of record-low money-market and bond yields, dividend-paying equities can offer an attractive source of income.

GLOBAL GORILLAS. We believe that investment in large, DM companies with outsized exposure to the emerging markets—we call them “global gorillas”—is another way to capture the growth from those markets. The EM economies now account for up to 80% of global GDP growth, a contribution that we believe is likely to be maintained for the foreseeable future. One way to capitalize on the growth in emerging economies is via established multinationals that have strong businesses in countries with a rapidly expanding middle class—such as China, India and Brazil, all of which are expected to see increases in consumer spending at an 8% annual rate over the next 10 years according to Euromonitor International, a market research firm. Our benchmark for the global gorillas is the S&P Global 100 Index.
EMERGING MARKET EQUITIES. Many EM countries do not face the debt burdens that are creating problems for developed countries, allowing for more fiscal policy flexibility. Meanwhile, as inflationary pressure has dissipated the monetary-tightening cycle has come to an end and policymakers have started to ease. Finally, from a valuation standpoint, the MSCI Emerging Markets Index, our benchmark appears cheap relative to its history and to the developed markets. In addition, EM equities in aggregate have higher dividend yields than DM equities. Thus, we maintain our constructive long-term outlook for this asset class.

INVESTMENT-GRADE CREDIT. We believe the very strong balance sheets of investment-grade companies will enable them to better withstand a slowdown in economic growth than at any point in recent history. A historically wide spread—or yield advantage versus low risk-free rates—and significantly lower volatility relative to other risk assets make a compelling case for investment-grade corporate bonds. Our benchmark is the Barclays Capital US Aggregate Corporate Investment Grade Index.

SHORT-DURATION BONDS. Given the potential for a recessionary backdrop and concerns about ongoing financial risks stemming from Europe, we have increased our allocation to safe-haven assets. Short-duration fixed income offers favorable yields relative to cash. Moreover, the defensive properties of this asset class should reduce volatility in diversified portfolios during turbulent periods. Our benchmark is the Barclays Capital Global Treasury 1-3 Years Index (hedged to the US dollar).

HIGH-QUALITY MUNICIPAL BONDS. The confluence of relative value versus US Treasuries, wide credit spreads, a historically steep yield curve and the expectation of continued low default rates suggests that high-quality municipal bonds should perform well in the coming year. We define “high quality” as bonds rated “A” or better. In addition, we prefer to keep to maturities of 15 years or less.

Specific points of value include A-rated general-obligation bonds, which trade at spreads that are more than double the long-term average of essential-service revenue bonds. We believe there is also opportunity in prerefunded bonds, which are generally backed by an irrevocable escrow of US government bonds and have been trading at relative-value levels well in excess of the historical average. Bonds with above-market coupons are also favored for income maximization and their defensive qualities. Our benchmark is the Barclays Capital AMT-Free Intermediate Continuous Municipal Index.
WATER. Water may be the most important commodity story of the 21st century as declining supply and rising demand combine to create the “perfect storm.” Current global water-usage levels are unsustainable. While the scarcity of freshwater is most acute in Africa and western Asia, scarcity also has become an economic constraint in major economies such as China, India and Indonesia, as well as in the commercial centers of Australia and the western US.

Indeed, urbanization may cause the demand for water to increase five-fold beyond the essential water requirement needed for personal hygiene, cooking and cleaning. Moreover, this does not include water used in power generation or other industrial activities that typically accompany urbanization. Finally, climate change is shrinking the available supply. In the face of progressively growing demand for water, companies are investing in ways to increase water availability (see Chart 2). Our benchmark is the ISE Water Index.
MANAGED FUTURES. Managed futures—funds and accounts that can take both long and short positions in futures contracts and options on futures contracts in the global commodity, interest rate, equity and currency markets—generally have low correlations of returns with stocks, bonds and other alternative asset classes, including hedge funds. These diversification benefits have the potential to lower the standard deviation of returns and improve the risk-reward profile of investment portfolios. What’s more, managed futures have historically performed well during adverse equity market conditions. Our benchmark is the CASAM CISDM CTA Equal-Weighted Index.

MASTER LIMITED PARTNERSHIPS. Master limited partnerships (MLPs)—limited partnerships that trade on a securities exchange—offer the tax benefits of the limited-partnership structure and the liquidity of publicly traded securities. MLPs are concentrated in natural-resource industries such as oil, natural gas and minerals extraction, and they are attractive to yield hunters for their usually robust quarterly dividend payouts. That yield has helped to lift recent years’ total returns on MLPs well above the total returns on the S&P 500 (see Chart 3).

As with real estate investment trusts, MLPs have a special status in the US tax code: They avoid state and federal corporate income taxes and must generate and pay out 90% of their income from producing, transporting and/or processing natural resources. Our benchmark for this investment is the Alerian MLP Index.

The MSSB Global Investment Committee includes: Jeff Applegate, Chief Investment Officer; David M. Darst, Chief Investment Strategist; Kevin Flanagan, Chief Fixed Income Strategist; Jonathan Mackay, Senior Fixed Income Strategist; Charles Reinhard, Deputy Chief Investment Officer, Douglas Schindewolf, Director of Asset Allocation.

Related Topics: Morgan Stanley Smith Barney (MSSB)