Wealth Management

GLOBAL INVESTMENT COMMITTEE / COMMENTARY

SEPTEMBER 2014

On the Markets MICHAEL WILSON Chief Investment Officer Morgan Stanley Wealth Management

Don’t Blink In last month’s On the Markets, we discussed the potential market impact of the Federal Reserve’s transition from the tapering of Quantitative Easing (QE) to the inevitable first interest-rate hike. We thought August might bring more volatility as the Fed began to walk investors down this path, first with the Jackson Hole symposium, followed by hints about what it might do at its next Federal Open Market Committee meeting on Sept. 17. We also suggested investors be ready to buy into weakness because we thought any market pullback would be short and sweet—and perhaps the last opportunity for investors to position themselves for the seasonally strong fourth quarter.

TABLE OF CONTENTS

2

A Framework for Flexible Investing Morgan Stanley & Co. introduces a way to think about cross-asset investing.

4

No Signs of Hubris and Debt Capex, inventories, staffing and debt are in check, so a stock market top is unlikely.

5

Opportunities in Innovative Disruption We look at long-term trends that may offer multiple avenues of investment.

7

What’s Holding Down Global Rates? The answer can be found in the beleaguered Euro Zone economies.

9

Bonds Unbound Nontraditional fixed income strategies may help investors withstand a rising interest rate environment.

10

Q&A: Getting in on the US Energy Renaissance Jerry Swank of MainStay Cushing Funds explains how MLPs invest in energy.

Lo and behold, global equity and credit markets sold off sharply during the first week of August. However, they rebounded just as sharply, with most ending the month in positive territory. If you blinked, you would have likely missed it. With August a popular time for market participants to take vacation, it’s likely many were caught offguard, either missing the chance to buy the dip or getting whipsawed both ways. The Global Investment Committee decided not to blink, and added exposure to both US equities and high yield credit shortly after prices bottomed. Whether this was a durable low for asset prices remains to be seen, but we believe it will prove to have been a good entry point for what we think is likely to be a solid finish to 2014. Our thesis remains the same as it’s been all year: The tapering of QE is the beginning of a Fed tightening cycle, but it is not the end of the economic and earnings expansion. Instead, the period is typically one when risky assets consolidate their initial strong postrecession gains exiting, a sort of pause that refreshes. While it may not seem like risky assets have consolidated much, we believe that global equity and credit markets have been going through a rolling correction since the middle of 2013, when the Fed initially raised the issue of tapering. The correction started with interest rate-sensitive securities last summer and possibly ended with European equities in August. The fourth quarter is typically a good time to be fully invested. Given 12 months of rolling corrections, we decided it’s probably better to be early than late to this year’s party. n

ON THE MARKETS / STRATEGY

A Framework for Flexible Investing ANDREW SHEETS Chief Cross-Asset Strategist Morgan Stanley & Co.

C

ross-asset investors, in the broadest sense, are those with the flexibility to move where global markets provide the greatest opportunity. Being in favor of “flexibility,” after all, feels a little obvious. We need to get more specific about the advantages. The advantages start with signals that market disconnects can provide, and the opportunity available to those who can shift between them. The last seven years are rich with examples. Credit weakness was an early warning for stock and government bond markets in 2007 and 2008, while European sovereign bonds returned the favor to equities and credit in 2011 and 2012. Forced selling in securitized and peripheral bonds, meanwhile, meant large rewards for those able to move between markets. Policy catalysts, from Quantitative Easing in the US to “whatever it takes” in the Euro Zone to Abenomics in Japan, rewarded flexibility in 2011, 2012 and 2013. REACTING TO VOLATILITY. Yet the growth and interest in cross-asset investing are also about something else. In 2008 and 2009, credit spreads hit levels last seen in the Great Depression, and global equity markets suffered a 58% peak-to-trough decline less than five years after experiencing a 49% decline from 2000 through 2003. Assets and regions that previously were thought to be independent became highly correlated, increasing volatility further. Given the current composition of retail and institutional assets, this matters. Individual investor ranks are increasingly dominated by baby boomers, whose proximity to retirement increases their aversion to risk. Meanwhile, pension funds

and insurance companies have seen solvency eroded by low yields and increased regulation. For a large swath of the global investor base, managing volatility matters as never before. REVISITING AGE-OLD PRINCIPLES.

This problem isn’t a new one. Investors have used asset-allocation theory for more than 60 years to try to maximize return and minimize volatility. Part of the resurgence of cross-asset investing is a renewed focus on these age-old principles, and taking them further. Following a crisis that saw many portfolios ill-suited to investor goals, this has often meant a shift toward “outcome-oriented investing,” trying to find a less volatile way to achieve returns. Cross-asset investing, in short, rests on three pillars: Identifying disconnects

between markets can provide important signals; flexibility is valuable in a world where opportunities have been uneven; and a broader approach should, in theory, make it easier to address end-investors more focused on risk-adjusted outcomes. When put together, our colleagues in financials equity research see the assets under management of multiasset funds, broadly defined, growing to $6 trillion by 2018, from less than $4 trillion now. CYCLICAL VIEWPOINTS. To build a cross-asset framework, we start with cycles because of the oscillating nature of growth, sentiment and valuation. While one’s cycle horizon can be 20 or more years, we’ll start with 10-year periods over which fundamentals and mean-reversion have tended to dominate asset prices: Long term (10 years). Long-run views help to set overall expectations, anchor shorter-term approaches and guide a large share of assets that are invested for the long term. Valuation and mean-reversion

The US Cycle: Still Not Full-Fledged Expansion Stage of the Cycle Attribute

Repair

Recovery

Expansion

Downturn

Economic Growth

Weak, Improving

Moderate, Improving

Strong, Plateauing

Weak, Deteriorating

Credit Growth

Weak

Accelerating

High

Falling

Central Bank Policy

Easy

Starting to Tighten

Tightening

Easing

Inflation

Low, Stabilizing

Moderate, Rising

High, Rising

Moderate, Falling

Yield Curve

Steep

Flattening

Flat/Inverted

Steepening

Asset Valuations Fundamentals

Below Average, Near Average, Above Average, Falling to Below Rising Rising Rising Average Profits ↓ Leverage ↓

Profits ↑ Leverage ↓

Credit Versus Credit, Equity Credit Preferred Equity Both Up Volatility

Profits ↑ Leverage ↑

Profits ↓ Leverage ↑

Equity Preferred

Credit, Equity Both Down

Above Average, Below Average, Below Average, Above Average, Falling Stable Rising Rising

Note: Gray boxes represent current stages of the US economic cycle. Source: Morgan Stanley & Co. Research as of Aug. 5, 2014

Please refer to important information, disclosures and qualifications at the end of this material.

September 2014

2

both become more important the longer one’s horizon, and will be central to how we approach long-run return estimates. This is also the period over which we would expect structural ideas play out. It’s no accident that Morgan Stanley & Co. Blue Papers, which look at shifts in industries and markets, often refer to changes that will take place over the coming decade. Medium term (five years). With longrun expectations set, adjustments are needed. Markets often overshoot, due to the ups and downs of the economy, sentiment and credit. While the business and credit cycles may differ, they often overlap. Both fall into four stages: ●Repair. The economic outlook is still challenged and uncertain, and companies shore up balance sheets while focusing on survival. Bondholders take precedence over stockholders, government and central bank policy is supportive, borrowing is weak and volatility is above average but falling. Equity valuations are below average and rising, credit spreads are above average and falling and the yield curve is steep. Think 2003 and 2009. ●Recovery. The economy gains momentum as confidence improves, inventories are rebuilt and investment and hiring resumes. Bondholders and shareholders benefit from stronger operations without excessive corporate risk-taking. Central bank and government policy becomes less accommodative, loan growth accelerates and volatility falls below average. As fear recedes, credit and equity valuations move from modestly cheap to modestly rich, and the yield curve flattens. Think 2004-2005, or today. ●Expansion. Optimism returns, and the scars of the last downturn are all but forgotten. Businesses are managed for stockholders at the expense of bondholders and show the necessary confidence to increase capital expenditures and undertake large-scale mergers and acquisitions. The growth of private debt accelerates, central banks tighten monetary policy, the yield curve trends toward inversion, equity valuations trend well above average and both inflation and volatility rise. Think 2006-07.

Cycle Indicator Suggests US in Early Expansion 0.4

Morgan Stanley Cycle Model Downturn Repair Recovery Expansion

0.3 0.2 0.1 0.0 -0.1 -0.2 -0.3 -0.4 '73

'78

'83

'88

'93

'98

'03

'08

'13

Note: Left scale indicates percentile deviation from trend Source: Morgan Stanley & Co. Research, Bloomberg, Datastream as of June 30, 2014

●Downturn. Credit-fuelled growth stalls, shaking the confidence in the boom that preceded it. Weakening cash flow in the face of still-high borrowing causes companies and consumers to cut back, a shock that is partially offset by central bank and government stimulus. Aboveaverage valuations fall below average, volatility rises, the yield curve steepens and inflationary pressures dissipate. No cycle, of course, is as simple as the above suggests. In aggregate, global markets still appear to be late in the recovery phase, despite central bank policy more consistent with a repair phase and credit market issuance and pricing more typical of expansion (see table, page 2). Yet this masks a highly unsynchronized cycle across the world, with Europe in the early stages and the US further along. Such unevenness could mean that the current expansion is unusually long, in our economists’ view. These qualitative assessments can be tested against a more quantitative approach. For the US, where we have the longest data set, we derive a cycle gauge (see chart) based on employment, credit conditions, corporate aggressiveness and the yield curve, with the overall reading based on the deviation of these metrics from the long-run trend. The cycle

Please refer to important information, disclosures and qualifications at the end of this material.

indicator suggests that the US is still in the early stages of the expansion phase. Near term (six to 12 months). For all that one can analyze long-term valuations and medium-term cycles, it is the shorter periods that put investments to the test. The pressure of quarterly and annual performance, along with the difficulty of forecasting earnings or default rates into the future, mean that many investors focus on the next six to 12 months out. How do we as cross-strategy investors address this? Over the very short term, six months or less, we plan on monitoring sentiment, flows and misalignment to identify opportunities, although we believe markets are noisier, that is, more random, the shorter the investment window. At the six-to-12-month horizon, we look for guidance to Morgan Stanley & Co.’s strategists, whose recommendations over this period are tailored to the fundamental, technical and valuation factors that matter most to their markets. These views, along with other factors, help us quantify how short-term performance may deviate from the waves of the longerrun cycle. n To see the full report on cross-asset strategy, ask your advisor for “CrossAsset Dispatches: Introducing Our Framework,” Aug. 5, 2014.

September 2014

3

ON THE MARKETS / EQUITIES

No Signs of Hubris and Debt in This Market ADAM S. PARKER, PhD Chief US Equity Strategist Morgan Stanley & Co.

T

he US stock market took a slight dip in late July and early August, but the water barely touched its ankles. The S&P 500 declined not quite 4% and turned upward. The index first closed at 2,000 on Aug. 26 and, three days later, finished the month at 2,003. The index is now a hair’s breadth from where we thought it would be late when we made our “2,014 in 2014” forecast in December. Even the 12-month update we made in June—2,050 by mid2015—is only 2.3% away (see table). It’s natural to question whether stocks are making a top. And if so, how would we call the top of the cycle? Our view is that hubris and debt define the top of every cycle, and as such, we monitor for signs of growing costs that could ultimately translate into more downside to corporate earnings. Today, it is hard to find evidence to make that argument. In fact, we think it is possible that capital intensity—the ratio of capital spending to sales—is now peaking for the biggest 1,500 US companies at around 7%, which is still below the 40-year median of 8.1%. CAPEX MUTED. A big increase in capital spending, while positive for GDP, would worry us because of the potential downside impact on earnings. The reason for that is that fixed costs, like a depreciation burden on cost of goods sold, can cause material downside to earnings in the event of a revenue shortfall. But for the moment, this doesn’t appear likely. We would wait for signs that backlogs are aging and growing or that book-to-bill ratios are well above 1.0 in the technology and industrial sectors before we’d expect to see a pickup in total capital spending.

We maintain our long-held stance that capital spending will remain muted. It is always difficult to assess aggregate inventory relative to sales, but it is worth pointing out that it has grown modestly recently. We don’t see this as a big impediment to margin expansion, but would be concerned if third-quarter earnings were to show bigger inventory expansion. Through the second-quarter earnings, we haven’t seen too many areas of concern for total inventory dollars in technology and industrials, and are encouraged that there will be less inventory expansion in the retail sector than there was last year. HIRING DISCIPLINE. In prior cycles, hiring has been another worrisome sign of management confidence. But this time, the largest companies really have maintained hiring discipline, showing a far slower growth rate in headcount than in revenue. So overall, we just don’t see enough capital spending, inventories or hiring to worry about a top in the cycle any time

soon. Can debt cause a problem? Interest coverage has markedly improved for the overall US market since the last crisis, from four times to nearly eight times during the past five years. This means that the odds of many companies experiencing difficulties in making their debt payments in the next few years are markedly lower than they have been in some time. Refinancing also shouldn’t be a problem for most companies for a while as most management teams have pushed out their financial obligations until 2017 or later, taking advantage of low cost of financing and credit availability. Overall, we just don’t see sufficient evidence, from a hubris and debt perspective, to worry about the top of the cycle or a large earnings contraction. n

MS & Co. S&P 500 Price Targets for Mid-2015 EPS Landscape Bull Case

Scenario Probability

2014E

2015E

2H15E1H16E

P/E Ratio

Scenario Target

Upside / Downside

20%

122.6

134.9

141.6

17.9

2,540

26.8%

11%

10%

10%

116.0

122.9

126.6

16.2

2,050

2.3%

5%

6%

6%

102.0

102.0

104.0

15.0

1,560

-22.1%

-8%

0%

2%

Growth Base Case

60%

Growth Bear Case

20%

Growth Current S&P 500 Price

2,003

Source: Thomson Reuters, Morgan Stanley & Co. Research as of Aug. 29, 2014 Please refer to important information, disclosures and qualifications at the end of this material.

September 2014

4

ON THE MARKETS / EQUITIES

Opportunities in Innovative Disruption DAN SKELLY Senior Equity Strategist Morgan Stanley Wealth Management

I

n the words of that ’80s cinematic iconoclast Ferris Bueller, “Life moves pretty fast. If you don't stop and look around once in a while, you could miss it.” With a nod to that classic line from Ferris Bueller’s Day Off, we pause from our usual equity market commentary to take a step back and examine what we view as disruptive trends that are running across multiple sectors and industries and having an impact on the way large companies operate. From studying these trends, we also hope to identify potential investment opportunities.

Cloud Computing The oft-cited “migration to the cloud” entails companies shifting on-premises enterprise servers to the Internet. This web-based cloud model allows companies to lower their information technology (IT) costs, improve application development and free up valuable resources that were previously spent on upgrading physical hardware. A proprietary survey conducted late last year by Morgan Stanley & Co. Research (MS & Co.) indicates that more than two-thirds of companies polled plan to be running workloads in the public cloud by the end of 2014, up from half at the end of 2013. What’s more, a June 2014 survey shows about 9% of their application workload in the cloud, and they expect that to grow to 15% by the end of this year and 21% by the end of 2015 (see chart). In addition, the latest quarterly survey of chief information officers by MS & Co.’s tech research team shows that cloud

computing topped the IT priority list for a third consecutive quarter. The implications of the shift to the cloud are significant. According to Katy Huberty, MS & Co.’s IT hardware analyst, the migration to cloud environments will be one of the primary drivers of technology spending during the next three years, producing significant growth opportunities for those companies positioned to provide cloud services or build cloud infrastructure. On the other hand, cloud migration will present significant challenges for vendors with products and services tied to on-site servers. We favor select providers of cloud application products and services, and would avoid companies with hardware products that may compete with the cloud.

Energy Efficiency As corporations deal with environmental regulations, geopolitical tensions

and managing profitability amid a frustratingly slow recovery, products and processes promoting energy efficiency are paramount. In North America, cheap and abundant natural gas is enabling companies to lower factory utilization costs. As a result, we are seeing some incremental manufacturing output shift back here and away from parts of Asia, where a decade of labor-cost inflation has also reduced the advantages of sending production offshore. Aside from costefficient manufacturing processes, we see two other areas clearly impacted by energy efficiency trends: transportation and building infrastructure. On the transportation front, we favor railroad companies, given their significant energy-efficiency advantage over truckers. We also like, as an example, providers of turbochargers and other products that improve automotive fuel efficiency. Finally, we favor companies that provide sophisticated motion-and-flowcontrol products that help reduce energy use in office buildings and industrial spaces. Energy efficiency is an important driver for upgrades in lighting; heating, ventilation and air-conditioning; and building controls (see chart, page 6).

Cloud Share Still Small, but Expected to Grow On Premise Co-Location

Managed Hosting Public Cloud

End of 2015

59%

End of 2014

13%

65%

June 2014

14%

71%

0%

20%

7%

40%

21%

6%

14%

60%

80%

15%

6%

9%

100%

Respondents

Source: Morgan Stanley & Co. CIO Survey as of June 25, 2014

Please refer to important information, disclosures and qualifications at the end of this material.

September 2014

5

Energy Efficiency Is Key Driver for Replacing Lighting, HVAC and Building Controls

Online/Mobile Retailing There’s typically a burst of consumer spending that accompanies an economic recovery, but that hasn’t been the case over the past few years. In the wake of the Great Recession, employment has been slow to recover, households have been focused on paying down debt instead of taking on new obligations and ultra-low interest rates have crimped cash flow for those who depend on interest income. That said, recent job growth and a likely imminent uptick in wages portend higher spending in the next year, according to Lisa Shalett, a member of the Global Investment Committee (GIC). We believe that a material amount of that spending will take place online rather than at traditional brick-and-mortar retailers. A MS & Co. AlphaWise survey suggests that global eCommerce’s penetration of retail sales will increase to more than 9% by 2016 from 6.5% today; if so, that means retail eCommerce would surpass $1 trillion. Furthermore, we believe that more of that spending will take place via mobile payments systems as smartphone usage increases. We favor retailers that have business models and core products inherently more insulated from online competition, namely club store discounters and homeimprovement stores. Home improvement fares well in an MS & Co. study of how threatened/insulated various types of

Critical Maintenance Energy Efficiency

80 % 70

6

60 50

30 18

40

24

67

30

43

20

34

5

0 HVAC

Building Control

retailers are from online competition (see chart, below). In clothing, we prefer apparel makers that have first-mover advantage online with the necessary supporting capital and scale. Last, we also like the network-payment processors given their “toll keeper” fee-based business models that benefit from increased transaction volume, whether it comes online, through mobile devices or via traditional physical locations.

The Internet of Things Perhaps one of the most far-reaching trends is the “Internet of things” (IoT), the fast-growing network connectivity of

Total

Omni-Channel Ready

Leases

Leverage Point

SKUs, Turns & ASPs*

Insulation (1-3 ranked best to worst)

Product Vulnerability

Superior Distribution

Supplier Mindset

Supplier Concentration

9

Fire Other Elevator Equipment Electrical Equipment Source: AlphaWise, Morgan Stanley & Co. Research as of Sept. 24, 2013 Lighting

Threats (1-3 ranked best to worst) Key Item Concentration

18

24

10

How Retailers Are Protected from Online Competition

Retail Category

30

33

Do-It-Yourself Auto

2

2

1

1

1

1

1

1

3

13

Home Furnishings

1

1

2

2

3

2

2

2

2

17

Home Improvement

1

2

2

2

2

2

1

1

2

15

Office Supply

3

2

3

2

3

2

1

2

3

21

Consumer Electronics

2

3

3

2

3

2

1

2

2

20

Sporting Goods

2

3

2

2

2

2

2

3

2

20

Pet Supply

3

2

1

3

2

3

2

2

3

21

Discount Stores

1

2

2

2

2

2

1

1

2

15

Vitamins/Supplements

2

2

2

3

2

2

2

2

2

19

Beauty

2

2

2

2

2

2

2

2

3

19

5 Security Equipment

everyday items enabled by the pervasive integration of semiconductors, mobile communication and “Big Data/Analytics.” A MS & Co. Blue Paper earlier this year discussed a range of potential applications from smart meters that enable better management of power and water to “precision agriculture” that provides farmers with data analysis and real-time recommendations, potentially changing the way farms operate and producing more food with fewer resources. (For an abbreviated version of the report, see the May 2014 On the Markets.) Additionally, in factories, the growing use of robotics and automation is leading to both improved efficiency and reduced energy usage. Lastly, for consumers, smart lighting in residences, connected cars with increased semiconductor content and wearable devices reflect the way that the IoT permeates our daily lives. For a play on the IoT, we favor automation product makers, agricultural companies that could benefit from increasing productivity and commodity yields, tech companies that make semiconductors and mobile brand leaders that provide wearable devices. n

*Stock-keeping units, inventory turns and average selling prices Source: AlphaWise, Morgan Stanley & Co. Research as of June 23, 2014 Please refer to important information, disclosures and qualifications at the end of this material.

September 2014

6

ON THE MARKETS / FIXED INCOME

What’s Holding Down Global Interest Rates? JONATHAN MACKAY Market Strategist Morgan Stanley Wealth Management JOHN DILLON Chief Municipal Bond Strategist Morgan Stanley Wealth Management

O

ne of the biggest surprises of the year has been the drop in global bond yields. Ten-year US bond yields are at their lowest level in more than a year and are down more than 60 basis points since the start of the year. In hindsight, some of the reasons for the drop in rates are obvious: weak GDP in the first quarter, the conflicts in Eastern Europe and the Middle East, concerns about growth in China and liability-driven investors like pension funds seeking to de-risk their portfolios. Finally, due to the declining budget deficit, the net issuance of Treasuries is projected to be down roughly 50% from 2013 and significantly lower than 2012 and 2011.Yet, it is the persistence of low rates that has been the real surprise. Economic data in the second quarter

has been consistently stronger than the first quarter, with GDP rebounding to a 4% annualized rate from -2.1% and the unemployment rate dropping to 6.2% from close to 7% at the beginning of the year. The ISM manufacturing and nonmanufacturing surveys, well-followed indicators of economic activity, are approaching a reading of 60, which in the past has been associated with very strong underlying growth. On top of this rebound in growth has been the fast-approaching end to the Fed’s tapering process, expected to conclude in October, which means the Federal Reserve will no longer be making net new purchases of assets and will only be reinvesting interest and principal payments. On the surface this seems like a recipe for higher rates. So what’s holding US Treasury rates down? BLAME THE BUND. We believe the primary culprit is Europe. Germany’s 10year Bund yield is below 1% and has been on a downward trajectory along with other

core European rates—France and Finland, for example—since the middle of 2013. The spread between the yield on the 10year US Treasury and the 10-year German Bund is currently 145 basis points; that’s more than two standard deviations above the long-term average of 40 basis points (see chart). The rest of Europe is no longer providing much yield pick-up either, with Spanish, Portuguese and Italian 10-year yields at 2.25%, 3.01% and 2.47%, respectively. Can European rates stay at these levels? We believe they can, but they could also drop further in the short term. Recent economic data has been soft even in the core of Europe, and inflation expectations are falling. The market seems to be making the wager that European Central Bank President Mario Draghi, after talking the talk for the past two years, will actually have to walk the walk and move forward with a Fed-like Quantitative Easing program. Draghi’s speech at the recent Jackson Hole conference was quite dovish as he specifically highlighted the recent drop in forward inflation expectations in the Euro Zone. US RATES ATTRACTIVE. For investors with a global mandate, US rates look relatively attractive versus the core of

The Spread Between US and German Yields Moved Toward Its All-Time High 200 Basis Points 169 150

145

100 50 0 -50 Spread, 10-Year US Treasury to 10-Year German Bund Highest Spread

-100 -150 -200 1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

Source: Bloomberg as of Aug. 25, 2014

Please refer to important information, disclosures and qualifications at the end of this material.

September 2014

7

Europe, and as an added bonus, the US dollar is on a strengthening trend versus the euro. This doesn’t mean US rates cannot move higher; they can. But if German yields stay at—or go below— current levels, we believe this will act as a restraint on any rise in US 10-year yields. In our view, the real risk for bond investors is a move higher in short rates, which will be driven by expectations for Fed rate hikes. And unlike the yield difference between the 10-year Treasury and the 10-year Bund, the difference between the two-year US Treasury and two-year German Bund is only 50 basis points. We believe the US yield curve will flatten as we move through this rate cycle, with short rates moving proportionately higher than long-term yields, similar to what happened in the 2004-to-2006 and 1994 cycles.

Municipals Going into the summer, the municipal bond market faced two primary risks that could have upset matters: the prospect of rising interest rates and the potential for outsized volatility from ongoing fiscal troubles in Puerto Rico, one of the muni market’s largest issuers. Instead, rates have rallied strongly, and Puerto Rico anxieties have diminished on the back of recent credit developments. The net result has been an overwhelmingly positive summer for municipal bonds, with the Barclays Municipal Bond Index now sporting a year-to-date total return of 7.4% (as of Aug. 28). These risks, however, have not been removed, just delayed. Despite mildly improving US economic data, US Treasuries have rallied on troubling

Even as Yields Fall, Muni Bond Inflows Continue 2.8 %

$ 900 700

2.7

500 2.6

300 100

2.5

-100 2.4

-300 -500

2.3

-700 2.2

-900 -1,100

Weekly Muni Fund Flows (millions, left axis) 10-Year AAA Muni Yield (right axis)

2.1

-1,300 -1,500 Jan '14

2.0 Feb '14

May '14

Jun '14

Aug '14

Source: Thomson Reuters Municipal Market Data, The Bond Buyer as of Aug. 21, 2014

geopolitical headlines. And as for Puerto Rico’s credit problems, the most recent fixes appear temporary. REDEMPTIONS DROP. Still, September is usually a quiet time for municipal bonds. While June, July and August are typically the three months with the largest redemptions, September often sees declines of more than 60% in the amount of cash in need of reinvestment. On the supply side, issuance is historically subdued, too, and helps investors gird for a jump in October, a month in which issuance typically sees increases of more than 30%. If evidence of a larger October primary supply surfaces by midSeptember, it could be a catalyst for market weakness and lead to lower prices and better entry points for investors. Given these developments, we are removing the constructive outlook we initiated in mid-April in favor of adopting

Please refer to important information, disclosures and qualifications at the end of this material.

a more cautious view. We may be early on this call, as the muni market shows few signs of weakness at the moment and could indeed trade sideways for weeks to come on scant new-issue supply, remaining redemption money on the sideline and muni fund inflows (see chart). BEST OPPORTUNITIES. We favor above-market (5% or higher) coupon structures in the steep four-to-nine-year maturity range. Continuing our “creditover-rates” theme, we also recommend extensions on the credit curve into Arated general obligation bonds, state housing finance authorities, higher education issuers and airports. We also favor AA-rated hospitals and BBB-rated water, sewer and public power revenue bonds. n

September 2014

8

ON THE MARKETS / FIXED INCOME

Taking the Nontraditional Approach to Fixed Income

range of strategies. Such strategies also entail higher credit, duration and other risks relative to traditional fixed-income strategies. Consulting Group Investment Advisor Research differentiates the nontraditional bond strategies as either “opportunistic” or “absolute return.” ABSOLUTE-RETURN STRATEGIES.

MATTHEW RIZZO Head of Investment Strategy & Content Consulting Group Investment Advisor Research Morgan Stanley Wealth Management STEVE LEE, CFA Senior Manager Research Analyst Consulting Group Investment Advisor Research Morgan Stanley Wealth Management

T

raditional fixed income strategies benefitted greatly from the threedecade decline in US interest rates. While these strategies remain critical to diversified portfolios, they may leave investors open to losses when interest rates are rising. In contrast, mutual funds following nontraditional strategies have shown the ability to offer current income, relatively low correlation to traditional investments and the potential to better withstand interest rate increases. An intermediate-term bond fund can shorten maturities in the face of rising rates, but only within the limits of its mandate; nontraditional bond funds have greater flexibility to adjust to a changing environment. OPPORTUNISTIC STRATEGIES.

Opportunistic funds may invest in high

yield bonds, international bonds, emerging market debt, bank loans, convertible securities and even preferred stocks. Some strategies may also include smaller allocations to equities, commodities and foreign currencies. Opportunistic strategies may employ various investment techniques including bottom-up security selection, top-down global macro analysis and sector rotation. Allocations can shift significantly over time, resulting in changing risk/return profiles. Duration* positioning varies widely. Many opportunistic managers try to adjust duration based on interest rate forecasts, benefitting from correct projections while mitigating principal loss when rates rise. And while greater exposure to creditsensitive sectors may result in less rate sensitivity, it also increases the correlation to equities. In addition, the dynamic, unconstrained method adds significant volatility. In a portfolio context, most opportunistic strategies may be used as complements to core fixed income strategies and not as substitutes. Utilizing nontraditional fixed income is complex as this label encompasses a wide

Nontraditional Bond Funds Under Various Conditions Rising Rate Quarters

Declining Rate Quarters

Rising Equity Quarters

Declining Equity Quarters

Multisector Fixed Income

1.5%

1.7%

2.4%

-0.3%

Nontraditional Fixed Income

1.7

0.9

2.3

-0.8

Barclays US Aggregate Bond Index

0.2

2.4

1.2

2.2

Note: Based on Morningstar mutual fund categories for 20 years ending June 30, 2014.* Rising/declining rate quarters based on interest rate movements of the 10-year US Treasury yield. For equities, rising/declining markets based on the S&P 500 total return. Indices are unmanaged and not available for direct investment. Index returns, unlike fund returns, do not reflect any fees or expenses. Past performance does not guarantee future results. Past performance is not indicative of future returns. Investment returns will fluctuate so that an investor’s shares when redeemed may be worth more or less than the original cost. Please note, current performance may be higher or lower than the performance data shown. Investors should carefully read the fund prospectus which includes information on the fund’s investment objectives, risk as well as charges and expenses along with other information. Investors should review the information in the prospectus carefully before investing. Source: Morningstar, CG IAR as of July 15, 2014 Please refer to important information, disclosures and qualifications at the end of this material.

Absolute-return strategies seek positive total return in all types of markets as opposed to benchmark-relative returns. They mostly target “cash-plus”—the 90day T-bill rate plus an additional return. The strategies also attempt to reduce volatility and avoid sizable drawdowns. But to achieve these objectives, absolutereturn managers may utilize derivatives such as forwards, options, futures and swap agreements more extensively than opportunistic strategies. And to prevent exposure to swings in rates or equity markets, these strategies often use shorting or leverage, which results in a risk-return profile that we believe qualifies some of these products as alternative mutual funds. Because absolute-return strategies aim for cash-plus returns, they tend to target lower levels of volatility and possess much lower correlations to equities than opportunistic strategies. As such, investors may substitute them for traditional fixed income strategies. How well have these strategies done? For opportunistic funds, we use Morningstar’s multisector fixed-income category as a proxy (see table). For the 20 years ending June 30, 2014, opportunistic funds outperformed the Barclays US Aggregate Bond Index during quarters in which interest rates rose and those in which equities appreciated. Morningstar’s nontraditional fixed income category, a proxy for absolute-return funds, also outperformed in rising interest rate periods. As interest rates are expected to normalize in coming years, we expect nontraditional fixed income to become important to many investors’ portfolios. n *For more about the risks to duration and alternative strategy mutual funds, please see Risk Considerations beginning on page 15.

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ON THE MARKETS / Q&A

MLPs: Getting in on the US Energy Renaissance

M

aster limited partnerships* (MLPs) have enjoyed quite a rally over the past five years amid a renaissance in the US energy industry. But Jerry Swank, managing partner at Cushing Asset Management and portfolio manager of MainStay Cushing Funds, notes that the US is still early in a multidecade build-out. Indeed, the Global Investment Committee (GIC) believes MLPs are a good way to invest in US energy due to their growing cash distributions and to long-term contracts, which allow many MLPs to operate as relatively insulated, utility-like business models. Swank recently spoke with Mike Wilson, chief investment officer of Morgan Stanley Wealth Management, about his outlook on energy and MLPs. The following is an edited version of their conversation.

MIKE WILSON (MW): What are your thoughts on the current US energy renaissance? JERRY SWANK (JS): What I want to impress on people, regarding the impact of shale drilling and fracking on energy supply in the US, is that this technology has changed the oil-and-gas business from a wildcat business to a manufacturing process. And the important thing is that the world’s largest consumer of hydrocarbons—oil and gas—is now also the cheapest and largest producer. This is going to cause major disruptions in the global economic continuum. It's going to change how energy is traded *For more about the risks to Master Limited Partnerships, please see Risk Considerations beginning on page 15.

around the world and also change industrial manufacturing and shipping. After decades of outsourcing manufacturing, industrial jobs are going to be brought back home because, with the exception of the Middle East, the cost of US natural gas is 25% to 30% less than the rest of the world. This is a huge advantage. We’ve seen this developing over the last few years, particularly among MLPs in what we call “the midstream business.” Having found all these new shale resources, we've had to replumb the pipelines and the energy infrastructure of the US. And that spending is going to be approximately $800 billion over the next 10 years, which is more than the entire market cap of the midstream industry right now. From our perch, it became obvious a couple years ago that there were a lot of things besides the midstream that are going to benefit—we've seen it in the entire energy value chain. MW: Can you explain what businesses operate in the different energy channels, and the relative attractiveness of each? JS: The upstream business is really the oil and gas reserves. Besides the exploration and production (E&P) companies, there are several upstream MLPs and some old oil-and-gas royalty firms. And these guys basically aren't in the exploration business; they're in the production business. We have relatively high current yields at this time, and we see the companies continuing to buy better, more stable declining reserves from the majors [oil companies]. The midstream is the sweet spot. Again, that's the pipeline and some transportation businesses, where we have a combination

Please refer to important information, disclosures and qualifications at the end of this material.

of nice current yield, and we see many years of sustainable and physical growth in the cash flow because of all these projects. Finally, the downstream is the refineries and chemicals companies as well as the shipping people, the barge companies, the rail companies, all the companies that are moving the commodities. The users of natural gas have been the beneficiaries. Those include the refining industries and the chemical businesses and the fertilizers, where there's a couple hundred billion dollars to be spent in new plants in the US, as well as in the business of liquefied natural gas. We never thought the US would be an exporter, but we will be. MW: Where is the US with regards to energy independence, and how far can we realistically expect to get down the road? JS: On the natural gas side, we have complete energy independence. We have probably 100 years of reserves, and so we will begin exporting that. On the oil side, we have increased production pretty dramatically, but we still import about 7 million barrels a day. About 3 million of that is from Canada, and will never go away. Most of the US refineries are set up for the heavy Canadian crude. But of the 4 million that's left—we're increasing the production from fields in the Bakken field (in North Dakota and Montana) and the Permian Basin and Eagle Ford in Texas by about a million a year. So in four years, we're going to be North America energy independent. MW: Do you think there could be a tax on these companies that makes it less economical or that the environmental costs are so great that the process itself could be curtailed? JS: Not to look at this with rose-colored glasses, but those just aren't the facts. When you put in sand and water and some chemicals you can find underneath your kitchen sink, it really hasn't been the drilling and the fracking where there's been any environmental issue.

September 2014

10

These wells are 7,000-to-9,000 feet below any water tables. The only [environmental] issue has been when the frack fluids come back up and how you dispose of the water. Five years ago, in several states, you didn't even have to get a permit to discharge the frack water. And now that's pretty tightly regulated, as it should be. And the industry, as you can imagine, is completely dedicated [to operating safely]. Every company that is in the water cleanup and purification business is getting increased focus. And I don't hear about a tax on it at all. MW: In early August, there was a large player that decided to consolidate some of its MLP assets and convert them back to a C-Corp. Does this activity signal something that we should be worried about, or do you feel like the MLP space is going to be well supported? JS: One of our themes [over] the last couple years has been the MLP-ification of the energy sector. Because of the relatively efficient tax structure, many companies have taken their MLP-able assets and put them in the MLP structure. There were 70 MLPs five years ago; we have 130 or 140 today. And because there's so much going on in the US and the midstream area, we think there will be a lot of M&A activity as additional companies choose to drop their qualifying assets into an MLP structure. I don't think this deal really says anything about taxes or structure. I think what it says is that there's a lot of opportunities. MW: Does anything concern you about the MLP category that could throw us for a loop or force a reset on valuation, other than individual issues with companies? JS: Just like any business, there's always execution risk. Across the board, I think the second quarter was the strongest quarter that we have ever seen. We had a decent correction, so we're kind of at the top end of the valuation range. But we still think the industry is set up for returns in the mid-teens. You just have to have a lot more selectivity, because there have been

companies that have benefited from the renaissance and some that haven't. And then I think the other most topical issue is interest rates. The “taper tantrum” in May 2013 hit all interest-sensitive sectors, but MLPs came back the fastest, and I think it's because people understand the growth in the distributions. Given a gradual increase in interest rates, we think MLPs will do fine. MW: What are the traits you look for in an individual MLP that make it one you want to own? JS: The key driver of MLP performance is the growth in the underlying distribution. But we also have had to understand the overall energy marketplace. The best example is one of the subsectors, natural gas long-haul transportation. That used to be a gold-plated business, shipping natural gas from the Gulf Coast to New York. But now with the Marcellus Shale Formation in the northeastern US, you don't need to ship that gas from the Gulf Coast. So you've had dispersions of returns in those industries. You've got to be very aware of how these trends are affecting businesses. Not everybody in the natural gas processing or crude oil space is a winner. MW: Within the energy complex, who are the big losers of the energy renaissance that you've described? JS: On the downstream, the companies that have a big foreign component—which isn't growing a lot—are the losers, and the winners are the companies that have a very high US domestic concentration. I think the challenge on the upstream is the E&P companies that do not have the shale play and have not been able to find the sweet spot. And the major integrated companies have not played this marketplace well at all. They just weren't aggressive enough in going out there and doing it, because it was a science project at first. MW: What regions of the world are going to feel the sting of this energy renaissance most? JS: First I'd just say, and I'm not being tongue-in-cheek, but I think the best emerging market in the world right now is between the Appalachians and the

Please refer to important information, disclosures and qualifications at the end of this material.

Rockies. The coasts are not benefiting at all—because there's no hydrocarbons produced there. So they're importers. But I would say that we’re basically putting the oil-and-gas refining business in Western Europe out of business. That's No. 1. Also, it’s going to hurt some manufacturing in China and in Japan and Korea, because they are paying $16 or $17 [per 1,000 cubic feet] for natural gas and it's $4 in the US. It's also hurting those businesses and industries built on cheap labor, as that advantage is not as big as it was and the energy cost advantage is really helping the US. MW: What do you think about longterm oil prices, given this renaissance in the US? And how should people think about energy costs going forward? JS: It's kind of a dichotomy, now, because oil is easily transportable, even though we can't export oil from the US yet. But we can export refined products. We're the only area in the world that is growing that production. When you look at the macro picture, you have slow economic growth and not really fast demand, so it [the price of oil] should be weak. Maybe crude should not be $110 a barrel; maybe it should be $95. But we have so many geopolitical issues around the world, from Sudan to Nigeria to what's happening in Iraq and Iran, that unless we have another 2008 [and the economy tanks], I think it will be very difficult for the bottom to fall out of the oil market. MW: So a stable environment for crude, generally? JS: Correct. n Jerry Swank is not an employee of Morgan Stanley Wealth Management. Opinions expressed by him are solely his own and may not necessarily reflect those of Morgan Stanley Wealth Management or its affiliates.

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Global Investment Committee Tactical Asset Allocation The Global Investment Committee provides guidance on asset allocation decisions through its various model portfolios. The eight models below are recommended for investors with up to $25 million in investable assets. They are based on an increasing scale of risk (expected volatility) and expected return. Hedged strategies include hedge funds and managed futures. >>>

CONSERVATIVE MODEL 1 14% High Yield

MODEL 2 1% Commodities

3% Emerging Markets Fixed Income

MODEL 3 2% Commodities

2% MLPs 6% Hedged Strategies and Managed Futures

2% REITs 1% Emerging Markets Fixed Income 8% High Yield

1% InflationLinked Securities

53% Investment Grade Fixed Income

>>>

MODERATE

14% Cash

3% MLPs

2% REITs

9% Hedged Strategies and Managed Futures

1% Emerging Markets Fixed Income

12% US Equity

9% Cash 16% US Equity

29% Cash 36% Investment Grade Fixed Income

15% International Equity

6% High Yield

28% Investment Grade Fixed Income

3% Emerging Markets Equity

>>>

MODERATE

3% Commodities

4% Cash

22% International Equity

5% High Yield

21% Investment Grade Fixed Income

4% High Yield 11% Investment Grade Fixed Income

4% MLPs 4% Commodities

13% Hedged Strategies and Managed Futures 1% Cash

3% REITs

24% US Equity

2% High Yield

26% International Equity

2% Investment Grade Fixed Income

28% US Equity 31% International Equity

12% Emerging Markets Equity

>>>

14% Hedged Strategies and Managed Futures

4% Commodities

12% Emerging Markets Equity

2% Cash

11% Emerging Markets Equity

MODEL 7

3% REITs

12% Hedged Strategies and Managed Futures

3% REITs

8% Emerging Markets Equity

AGGRESSIVE

4% MLPs

4% MLPs

20% US Equity

3% REITs

MODEL 6

MODEL 5

11% Hedged Strategies and Managed Futures

3% Commodities

6% Emerging Markets Equity

>>>

MODEL 4 3% MLPs

18% International Equity

MODEL 8 4% MLPs

14% Hedged Strategies and Managed Futures 3% Cash

4% Commodities 32% US Equity

31% International Equity

CASH 26% US Equity

3% REITs

14% Emerging Markets Equity

KEY

35% International Equity

GLOBAL FIXED INCOME

GLOBAL EQUITIES

ALTERNATIVE INVESTMENTS

Note: Hedged strategies consist of hedge funds and managed futures.

Please refer to important information, disclosures and qualifications at the end of this material.

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12

Tactical Asset Allocation Reasoning Global Equities

Relative Weight Within Equities

US

Overweight

While US equities have done exceptionally well since the global financial crisis, they still offer attractive upside potential, particularly relative to bonds. We believe the US and global economy continue to heal, making recession neither imminent nor likely in 2014 or 2015. This is constructive for global equities, including the US.

International Equities (Developed Markets)

Overweight

We maintain our bias for Japanese and European equity markets given the political and structural changes taking place in Japan and an improving economic outlook in Europe. Japan underperformed in the first half of 2014 due to the recently enacted consumption tax. We expect the second half to be better as consumption rebounds. Europe performed well during the first half, but has sold off sharply on concerns about Russia/Ukraine and the ongoing Asset Quality Reviews (AQRs) and bank stress tests. We believe most of the bad news is priced in and would add on weakness before the AQRs and stress tests are completed in October.

Underweight

Emerging markets have surprised to the upside this year. However, we believe performance may be ahead of the fundamentals and remain underweight. Policy remains out of sync with what is necessary for true reform in many regions. The Fed’s rate hike cycle, likely to begin early next year, could have a negative impact. We would only add on pullbacks and favor India, Mexico, China, Taiwan and Korea.

Emerging Markets

Global Fixed Income US Investment Grade

International Investment Grade Inflation-Linked Securities

High Yield

Emerging Market Bonds

Alternative Investments

Relative Weight Within Fixed Income Overweight

Equal Weight

Underweight

Overweight

Underweight

We have recommended shorter-duration (maturities) since March 2013 given the potential capital losses associated with the rising interest rates from such low levels. Yields have risen since then, but not enough for us to change that advice. However, we recently reduced the size of our overweight in short duration as we expect short-term interest rates to move higher than the market expects in the next six months. Within investment grade, we prefer BBB-rated corporates and A-rated municipals over US Treasuries. Yields are low globally, so not much additional value accrues to owning international bonds beyond some diversification benefit. We have been underweight inflation-linked securities since March 2013, given negative real yields across all maturities. Recently, these yields have turned modestly positive but remain unattractive, in our view, due to the longerduration characteristics of TIPS. Yields and spreads are near record lows. However, default rates are likely to remain muted as the economy recovers slowly, keeping corporate and consumer behavior conservative. We prefer shorter-duration and higher-quality (B to BB) issues and vigilance on security selection at this stage of the credit cycle. Similar to emerging market equities, we remain underweight on the basis that the beginning of the Fed’s rate hike cycle will likely be a disproportionate headwind for emerging market debt relative to other debt markets.

Relative Weight Within Alternative Investments

REITs

Equal Weight

Falling interest rates have led to very good performance from REITs this year. At current levels, we believe REITs are fairly valued and offer select opportunities. The industrial and commercial segments tend to outperform at this stage of the recovery. Non-US International REITs should also be favored relative to domestic REITs at this point.

Commodities

Equal Weight

Commodities have performed much better in 2014 than in the recent past. Poor weather and rising geopolitical risks have led to higher prices, reminding us that commodities can provide some ballast to a traditional equity/bond portfolio. There is also a growing appreciation that China is not the only driver of demand for commodities.

Master Limited Partnerships*

Equal Weight

Master limited partnerships (MLPs) should continue to do well as they provide diversification benefits to traditional assets and a substantial yield that is valuable in a low interest rate world. Many MLPs are levered to commodity consumption, which is more predictable than prices.

Hedged Strategies (Hedge Funds and Managed Futures)

Equal Weight

This asset class can provide uncorrelated exposure to traditional risk-asset markets. It tends to outperform equities when growth slows and works well in more challenging financial markets.

Source: Morgan Stanley Wealth Management GIC as of Aug. 29, 2014

Please refer to important information, disclosures and qualifications at the end of this material.

September 2014

13

ON THE MARKETS

Index Definitions

INSTITUTE OF SUPPLY MANAGEMENT (ISM) NONMANUFACTURING INDEX An index based

BARCLAYS MUNICIPAL BOND INDEX This is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market.

surveys of nonmanufacturing firms by the Institute of Supply Management. The ISM Nonmanufacturing Index monitors employment, new orders and supplier deliveries. A composite diffusion index is created that monitors conditions in national nonmanufacturing industries based on the data from these surveys.

BARCLAYS US AGGREGATE BOND INDEX This

index tracks US-dollar-denominated investment grade fixed rate bonds. These include US Treasuries, US-government-related, securitized and corporate securities.

Glossary CORRELATION A statistical measure of how two securities move in relation to each other. This measure is often converted into what is known as correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation coefficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random. A correlation greater than 0.8 is generally described as strong, whereas a correlation less than 0.5 is generally described as weak.

S&P 500 INDEX Regarded

on

This term refers to the largest cumulative percentage decline in net asset value or the percentage decline from the highest value or net asset value (peak) to the lowest value net asset value (trough) after the peak. DRAWDOWN

The sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is motivated by the belief that a security's price will decline, enabling it to be bought back at a lower price to make a profit. Short selling may be prompted by speculation, or by the desire to hedge the downside risk of a long position in the same security or a related one.

SHORT SELLING

as the best single gauge of the US equities market, this capitalizationweighted index includes a representative sample of 500 leading companies in leading industries in the US economy.

STANDARD DEVIATION This

statistical quantifies the volatility associated with a portfolio’s returns by measuring the variation in returns around the mean return. Unlike beta, which measures volatility relative to the aggregate market, standard deviation measures the absolute volatility of a portfolio’s return.

Please refer to important information, disclosures and qualifications at the end of this material.

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Risk Considerations Alternative Strategy Mutual Funds Alternative strategy mutual funds may employ various investment strategies and techniques for both hedging and more speculative purposes such as short-selling, leverage, derivatives and options, which can increase volatility and the risk of investment loss. Non-traditional investment options and strategies are often employed by a fund’s portfolio manager to further a fund’s investment objective and to help offset market risks. However, these features may be complex, making it more difficult to understand the fund’s essential characteristics and risks, and how it will perform in different market environments and over various periods of time. They may also expose the fund to increased volatility and unanticipated risks particularly when used in complex combinations and/or accompanied by the use of borrowing or “leverage.” The fund’s prospectus will contain information and descriptions of any non-traditional and complex strategies utilized by the fund.

MLPs Master Limited Partnerships (MLPs) are limited partnerships or limited liability companies that are taxed as partnerships and whose interests (limited partnership units or limited liability company units) are traded on securities exchanges like shares of common stock. Currently, most MLPs operate in the energy, natural resources or real estate sectors. Investments in MLP interests are subject to the risks generally applicable to companies in the energy and natural resources sectors, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk. Individual MLPs are publicly traded partnerships that have unique risks related to their structure. These include, but are not limited to, their reliance on the capital markets to fund growth, adverse ruling on the current tax treatment of distributions (typically mostly tax deferred), and commodity volume risk. The potential tax benefits from investing in MLPs depend on their being treated as partnerships for federal income tax purposes and, if the MLP is deemed to be a corporation, then its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution to the fund which could result in a reduction of the fund’s value. MLPs carry interest rate risk and may underperform in a rising interest rate environment. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments; this deferred tax liability is reflected in the daily NAV; and, as a result, the MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked.

Duration Duration, the most commonly used measure of bond risk, quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the bond or portfolio would be to changes in interest rates. Generally, if interest rates rise, bond prices fall and vice versa. Longer-term bonds carry a longer or higher duration than shorter-term bonds; as such, they would be affected by changing interest rates for a greater period of time if interest rates were to increase. Consequently, the price of a long-term bond would drop significantly as compared to the price of a short-term bond.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. Alternative investments which may be referenced in this report, including private equity funds, real estate funds, hedge funds, managed futures funds, and funds of hedge funds, private equity, and managed futures funds, are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and risks associated with the operations, personnel and processes of the advisor. Managed futures investments are speculative, involve a high degree of risk, use significant leverage, have limited liquidity and/or may be generally illiquid, may incur substantial charges, may subject investors to conflicts of interest, and are usually suitable only for the risk capital portion of an investor’s portfolio. Before investing in any partnership and in order to make an informed decision, investors should read the applicable prospectus and/or offering documents carefully for additional information, including charges, expenses, and risks. Managed futures investments are not intended to replace equities or fixed income securities but rather may act as a complement to these asset categories in a diversified portfolio. Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events,

Please refer to important information, disclosures and qualifications at the end of this material.

September 2014

15

war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention. Physical precious metals are non-regulated products. Precious metals are speculative investments, which may experience short-term and long term price volatility. The value of precious metals investments may fluctuate and may appreciate or decline, depending on market conditions. If sold in a declining market, the price you receive may be less than your original investment. Unlike bonds and stocks, precious metals do not make interest or dividend payments. Therefore, precious metals may not be suitable for investors who require current income. Precious metals are commodities that should be safely stored, which may impose additional costs on the investor. The Securities Investor Protection Corporation (“SIPC”) provides certain protection for customers’ cash and securities in the event of a brokerage firm’s bankruptcy, other financial difficulties, or if customers’ assets are missing. SIPC insurance does not apply to precious metals or other commodities. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio. Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one's state of residence and, if applicable, local tax-exemption applies if securities are issued within one's city of residence. Treasury Inflation Protection Securities’ (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation. Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Derivative instruments. Options, futures contracts, options on futures contracts, forward contracts, swaps and structured products are examples of derivative instruments. Risks of derivative instruments include imperfect correlation between the value of the instruments and the underlying assets; risks of default by the other party to certain transactions; risks that the transactions may result in losses that partially or completely offset gains in portfolio positions; and risks that the transactions may not be liquid. Please see the fund’s prospectus for additional information. Options are not suitable for every investor. This sales material must be accompanied by or preceded by a copy of the booklet 'Characteristics and Risks of Standardized Options' (ODD). Investors should not enter into options transactions until they have read and understood the ODD. Before engaging in the purchase or sale of options, investors should understand the nature of and extent of their rights and obligations and be aware of the risks involved, including, without limitation, the risks pertaining to the business and financial condition of the issuer of the underlying security or instrument. Options investing, like other forms of investing, involves tax considerations, transaction costs and margin requirements that can significantly affect the profit and loss of buying and writing options. The transaction costs of options investing consist primarily of commissions (which are imposed in opening, closing, exercise and assignment transactions), but may also include margin and interest costs in particular transactions. Transaction costs are especially significant in options strategies calling for multiple purchases and sales of options, such as multiple leg strategies, including spreads, straddles and collars. A link to the ODD is provided below: http://www.optionsclearing.com/about/publications/character-risks.jsp. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Smith Barney LLC retains the right to change representative indices at any time. REITs investing risks are similar to those associated with direct investments in real estate: property value fluctuations, lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Please refer to important information, disclosures and qualifications at the end of this material.

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Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. The majority of $25 and $1000 par preferred securities are “callable” meaning that the issuer may retire the securities at specific prices and dates prior to maturity. Interest/dividend payments on certain preferred issues may be deferred by the issuer for periods of up to 5 to 10 years, depending on the particular issue. The investor would still have income tax liability even though payments would not have been received. Price quoted is per $25 or $1,000 share, unless otherwise specified. Current yield is calculated by multiplying the coupon by par value divided by the market price.

The initial rate on a floating rate or index-linked preferred security may be lower than that of a fixed-rate security of the same maturity because investors expect to receive additional income due to future increases in the floating/linked index. However, there can be no assurance that these increases will occur. The market value of convertible bonds and the underlying common stock(s) will fluctuate and after purchase may be worth more or less than original cost. If sold prior to maturity, investors may receive more or less than their original purchase price or maturity value, depending on market conditions. Callable bonds may be redeemed by the issuer prior to maturity. Additional call features may exist that could affect yield. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Credit ratings are subject to change. Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom. Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, sale, exercise of rights or performance of obligations under any securities/instruments transaction.

Disclosures Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein.

Please refer to important information, disclosures and qualifications at the end of this material.

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This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material. Morgan Stanley Wealth Management and its affiliates do not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used or relied upon by any recipient, for any purpose, including the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Each client should consult his/her personal tax and/or legal advisor to learn about any potential tax or other implications that may result from acting on a particular recommendation. This material is disseminated in Australia to “retail clients” within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813). Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the research in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities. Morgan Stanley Private Wealth Management Ltd, authorized by the Prudential Regulatory Authority and regulated by the Financial Conduct Authority and the Prudential Regulatory Authority, approves for the purpose of section 21 of the Financial Services and Markets Act 2000, research for distribution in the United Kingdom. Morgan Stanley Wealth Management is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. Morgan Stanley Wealth Management research, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC. © 2014 Morgan Stanley Smith Barney LLC. Member SIPC.

Please refer to important information, disclosures and qualifications at the end of this material.

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