Global Recovery Underway - Citi Private Bank · rate declined in July for the first time in 20...

investment outlook sePtemBeR 2009

The stock market’s discounting •mechanism page 4

Seeking dividends in Europe • page 6

Emerging markets sprint ahead •page 7

Nine Signposts for 2009: an •update page 9

Central banks consider exit •strategies page 10

Commodities’ cyclical comeback• page 13

Adding to record hedge fund •returns page 14

CitiGRouP GloBAl mARkets inC.

Global Recovery UnderwayThis time around, the developing economies—not the US—are out in front By Jeff ApplegAte, DAviD M. DArst AnD ChArles reinhArD

From all over the world, unmistakable signs are emerging that an economic

recovery is underway. Surveys of purchasing managers in China, Europe, the UK, Japan, Mexico and the US all point toward greater manufacturing activity. Improved corporate bond spreads and higher stock markets reflect better financial conditions. The US unemployment rate declined in July for the first time in 20 months, falling 0.1% to 9.4%, and the S&P/Case-Shiller Index of US home prices for 20 metropolitan areas rose in May for

the first time in 34 months, up 0.5%—followed by a 1.4% gain in June. Home prices are also rising in Australia and the UK, and unem-ployment rates have also dipped in Spain, Brazil and Mexico.

Unlike past recoveries, which were spearheaded by the US, the developing economies are showing the ability to grow on their own. Incremental household consump-tion in the BRIC countries—Brazil, Russia, India and China—has been increasing by a larger amount, measured in US dollars, than US household consumption since 2007; BRIC consumption in 2008 rose $765 billion versus $349 billion in the US (see chart, page 2). Morgan Stanley & Co. Incorporated and Citi economists expect stronger economic

and earnings growth in these areas than in the developed ones, both for 2009 and 2010. Developing country GDP is expected to grow more than 5% in 2010, versus developed coun-try GDP growth of less than 2%. Given an 80% correlation between the magnitude of recessions and subsequent recoveries since World War II, history suggests the risk in the early phase of the recovery is that growth could exceed expectations.

Fostering the recovery is the overwhelming policy response. In key developed economies, monetary policy continues to keep interest rates low—and rates are expected to remain low for an extended period. In the US, Presi-dent Barack Obama nominated

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Fed Chairman Ben Bernanke for a second term, which should provide continuity of leadership for the central bank and the economy.

PRoFits PiCk uP. Second quarter US pro-ductivity growth of 6.4% is good news for prof-its; the flip side of high productivity means that unit labor costs—the biggest expense for most firms—are in check. Morgan Stanley and Citi both expect double-digit profit growth for the Standard & Poor’s 500 in 2010. Profits usually benefit from higher productivity coming out of recessions. During such periods investors focus on earnings growth as their primary driver rather than expanding price/earnings ratios.

We believe that we are six months into a multiyear bull market that will be powered by sustained profit growth. Since 1926, US equity market advances between 20% corrections have featured an average duration of slightly more than two years. In those instances where an ad-vance exceeded the highest price recorded dur-ing the prior advance—which happened when

the S&P 500 first topped its January 2009 high in June—the average bullish advance has lasted slightly longer than four years.

tHe WAll oF WoRRY. An old Wall Street adage is that bull markets climb a wall of worry—and there are plenty. One concern is that reduced household wealth from the declines in home and equity prices, combined with ris-ing unemployment, will force consumers into a prolonged period of high saving and lackluster spending. Indeed, a long-term relationship exists between the personal savings rate and the level of household net-worth-to-disposable or after-tax income. Consumers tend to spend more and save less of their income when they feel cushioned by rising stock and housing markets. Since March 9, the market capitalization of the US equity market has increased almost $4 trillion and median existing home prices, at $181,800 in June, are up from their $164,800 low in January. The upshot: Households may have a greater willingness to spend. Thus, the US household savings rate may have peaked.

Other concerns have centered on the recent rise in US Treasury yields and commodity pric-es. Oil has climbed to over $70 per barrel. The normal cyclical pattern is for government bond yields to rise and commodity prices to increase as a recovery takes hold. This has not precluded a recovery in the past, nor should it now.

A DouBle-DiP ReCession? Some worry that the underlying economy is so fragile that once the stimuli wear off, growth will slump, producing a so-called double-dip recession. In our opinion, this concern is overwrought. First, most of the $500 billion spending in the $787 billion US stimulus plan has yet to be released. Second, it would take a substantial hike in short-term interest rates to restrict growth. Be-cause monetary policy works with a consider-able lag, in our view the full impact of past rate cuts has not yet been felt. Finally, while central

Global Recovery Underway

By Jeff ApplegAte Chief Investment Officer Morgan Stanley Smith Barney

By ChArles reinhArDGlobal Investment Strategist Morgan Stanley Smith Barney

Consumer Powerhouses Brazil, Russia, India and China—the so-called “BRIC” nations—are in a position to lead the global recovery. Household consumption in the BRIC bloc is increasing by a greater amount than in the US.

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By DAviD M. DArst, CfA Chief Investment StrategistMorgan Stanley Smith Barney

2SEPTEMBER2009•CiTiPRivaTEBank

Cover story

This piece is primarily authored by, and reflects the opinions of, Morgan Stanley Smith Barney LLC, Member SIPC, as well as identified guest authors.

bankers have talked about exit strategies related to their Quantitative Ease (QE) campaigns, QE will still be in effect for the foreseeable future.

Many worry about high inflation in the wake of the huge policy response. In our view, such concern is unwarranted; to have signifi-cant inflation would require a major policy error by the same people who managed to avoid another Great Depression. Moreover, the Eco-nomic Cycle Research Institute’s Future Infla-tion Gauge for the US is just now coming off a 51-year low, suggesting that a decisive upswing in inflation is not at hand (see chart).

Well-PRiCeD Risk. All told, we believe that risk assets—namely equities, high-grade and high yield corporate bonds, real estate invest-ment trusts, and commodities—are attractively priced relative to “safe-haven” assets such as cash and sovereign debt. As a result, our asset allocation overweights global equities and cycli-cally sensitive alternative/absolute return invest-ments and underweights government bonds and cash (see page 12).

Within global equities, we are tactically over-weight emerging markets as well as US small-cap and mid-cap stocks. The reasoning is this: Emerging market stocks possess robust growth characteristics and, together with small caps, normally outperform large caps coming out of recessions. We are also overweight commodity currency-sensitive developed equity markets, mainly Canada and Australia; the former has more exposure to energy, while the latter has exposure to metals. At this point we are under-weight all other developed equity markets: the US, Europe and Japan.

Within global fixed income, we are under-weight developed economy government debt and overweight high-grade and high yield corporate debt, both of which still offer larger-than-normal spreads over government fixed income securities. In light of steep yield curves,

where longer-maturity debt offers meaningfully higher yields than shorter maturities, we are also underweight short-duration debt. Finally, the low level of short-term rates leaves us un-derweight cash.

A recovering global economy, along with the continuing industrialization of many emerging market economies, should lift demand for com-modities. An upturn in economic conditions should also improve the supply/demand balance for commercial real estate. As a result, we have tactical overweight positions in two liquid alter-native/absolute return investments: commodi-ties and real estate investment trusts (REITs).

Since global policymakers have successfully avoided what could have been a second Great Depression, the global economy and asset markets appear to us to be steadily scaling the proverbial wall of worry. We remain mindful that garden-variety setbacks and corrections are both inevitable and healthy. Hopefully, we are positioned to take advantage of such worries to achieve portfolio growth in the period ahead.

A “no inflation” Forecast. The Economic Cycle Research Institute’s Future Inflation Gauge is just coming off a 51-year low. That means a significant upswing in inflation is unlikely.

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Data Source: Economic Cycle Research Institute as of 31 July 2009

SEPTEMBER2009•CiTiPRivaTEBank 3

As the final quarter of the year ap-proaches, many investors and busi-nesses are pinning their hopes on

the consumer, with an eye toward the holiday shopping season. However, much of the data has not been encouraging. Year-over-year retail sales are negative. After improving in the spring, the University of Michigan consumer sentiment data has weakened. Unemployment remains stubbornly high. Households are saving at a rate of 4.2%, up from zero several years ago.

Even with this somewhat downbeat data on consumers, the US stock market is strong. Since the Standard & Poor’s 500 intraday low of 666 on March 9, the stock market has rallied 52% through Aug. 28. The S&P’s price/earnings ratio climbed from 11.1 times to 16.9 times, based on year-end 2009 forecasts. The current valua-tion suggests to us that investors are forecasting a fairly rapid return to more-normal conditions. And indeed, that is happening in many parts of the economy. Credit spreads have narrowed significantly, and there is a consensus view that

the economy will record positive growth in the current quarter. Yet, the S&P Consumer Discretionary Index is up 66% since the March bottom without a corresponding rise in revenues and earnings and while consumers are strug-gling on many fronts (see chart). This raises the question “what are investors missing?” Or, conversely, “what are investors seeing?”

lookinG AHeAD. Financial theorists have long viewed the stock market as a discounting mechanism. That is, today’s market action is ac-tually anticipating events that will be occurring, typically, six to nine months ahead. Indeed, that could be one explanation for the global market rally that began in March when the economic and financial data were still terrible. By rallying in March, the market may have been looking for better times toward the end of this year.

For most of this decade, however, the discount mechanism hasn’t worked that well. Indeed, the S&P 500 and corporate profits have moved virtually in lockstep, with investors reacting instantly to the day’s news. To us, the rapid expansion in the market multiple over the last six months, the result of prices running far ahead of earnings, points to a return of the discounting mechanism (see chart, page 5).

enCouRAGinG eARninGs. Given the strong relationship between earnings and share prices over time, it is important to gauge current trends in corporate profits. Cuts to estimates made when the economic outlook was at its worst have proved to be too pessimistic. The aggressive global monetary and fiscal policy re-sponses have taken the “worst-case” scenario off the table. Second-quarter earnings have largely surprised to the upside, on the strength of dis-ciplined expense control. Of the 488 S&P 500 companies that had reported second-quarter earnings through Aug. 25, 353 had beaten es-timates and 93 had missed, with the remainder right on target. Therefore, the second-quarter

The Return of the Discounting Mechanism

By MArshAll KAplAn Senior Equity Strategist Private Client Investment Strategy Citi

on the Come Consumer discretionary stocks have been even stronger than the S&P 500, a curious situation since consumers are struggling with debt, loss of wealth and job-lessness. Investors apparently are looking past those ills.

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By steve howArD Senior Equity StrategistPrivate Client Investment StrategyCiti

equities


2009 ratio thus far—deep into the earnings re-porting season—of positive to negative surprises is 3.8 versus a first-quarter 2009 ratio of 2.5. In aggregate, second-quarter 2009 share-weighted results are beating expectations by 9.1% but are down nearly 30% from a year ago.

Citi economists raised their forecasts for S&P 500 operating earnings (before write-offs) for the second time in a month. These positive revisions have taken Citi’s forecasts meaningfully higher than the bottom-up analyst forecasts for the first time in many months. Bottom-up ana-lyst earnings-per-share forecasts, which troughed in mid May, likely will begin to move signifi-cantly higher, if economists are correct.

sentiment moves to neutRAl. We have long focused on the importance of sentiment in determining market direction. In recent weeks, we theorized that the market could continue to move higher, propelled by rising earnings esti-mates and a fearful investor base. The rally that has taken place has now lifted Citi’s proprietary Panic/Euphoria Model back into the neutral zone, an indication to us that sentiment may be less helpful for the market in coming months.

In the recovery thus far, the consumer has been a laggard. The recent strength in stocks—consumer stocks in particular—suggests that any improvement is indeed on the come. His-tory is on the side of the market, as the indefati-gable consumer rarely lets the market down for long, particularly around the holidays. However, there is evidence that the normal march back into the malls may be more of a crawl.

tHe oil CARD. Though oil is down signifi-cantly from a year ago, investors should keep an eye on the price. Consumers, while less energy dependent than a generation ago, still see energy as a big item on the household budget. If prices continue to rise, it could serve as an additional tax on consumers. According to Citi economists, a penny change in the price of a

gallon of gasoline represents approximately $1.2 billion in consumers’ wallets on an annualized basis. To put it in perspective, the much talked about “cash for clunkers” program allocated $3 billion toward the purchase of new, fuel-efficient vehicles. The rise in gas prices since early this year—approximately $1 per gallon—represents an incremental $120 billion cost to consumers.

Looking ahead, we believe investors may benefit from a focus on quality. Year to date, the market discounting mechanism has produced big returns for the most-beleaguered areas of the market. If the discounting mechanism needs to be recalibrated later in the year—perhaps due to a slower recovery—investors would be better served by companies with strong balance sheets, positive free-cash-flow generation and defensible operating margins. Even if the discounting mechanism is up to task, we think that these sorts of firms may take on a market leadership role after having ceded the stage to lower-quality players in the initial stages of the recovery.

Discount mechanism Stocks are going up while trailing 12-month earnings are still declining. That shows investors are again discounting future developments in today’s prices.

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S&P 500 Trailing 12-Month EPS (right scale)

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Data Source: Bloomberg as of 31 July 2009


After a 40%-plus climb in equity prices, some investors are worry-ing that the move is nearly over and

perhaps wondering if they should get out. Others who stayed on the sidelines are just now thinking about getting into the market. Either sort of investor could be well served by focusing on stocks that pay high dividends.

Don’t underestimate the power of divi-dends. In the US, for instance, they account for half of the returns from equities over the last 130 years. Ignore dividends and the po-tential long-term performance suffers.

euRoPe’s PRemium PAYout. Europe is a good place to shop for dividends. The 3.8% dividend yield compares favorably both relative to its peers and to other asset classes. In the aggregate, the region provides a 40% premium to the global ex Europe dividend average of 2.3%. Within Europe, there are many markets where investors can earn even more—5% in Spain, 4.4% in Portugal, 4.1% in the UK and 4% in France. Viewing the

market by sector, telecoms yield 6.6%, utili-ties 5.6% and energy 5.6%. Furthermore, the superior yields tend to come from large, blue-chip companies.

The European dividend yield is also attrac-tive relative to other asset classes. Ten-year government bonds yield 3.5% in the UK and France and 3.3% in Germany. Indeed, the chart below shows that this is the first time in 20 years that dividend yields have risen above bond yields. While the magnitude of the premium has recently eroded, in our view, the fact that equity dividend yields remain above those of bonds is both a positive indicator for equities and an opportunity for investors.

loW-RAte BACkDRoP. Likewise, we believe that with central bank interest rates at record low levels—0.5% in the UK and 1% in the Euro Zone—it is difficult to argue for the relative merits of cash. In addition, with our economists forecasting no change in policy interest rates until the second quarter of 2010, the attractiveness of high-yielding equities is likely to remain. Even when cen-tral banks start raising rates, those rates will begin from such a low point that they won’t be able to compete with dividend yields for some time.

Given current market conditions and the historic impact of dividends on investment returns, we believe that investors should con-sider the compelling dividend yields that can be found in Europe.

Europe’s Attractive Dividend Yields

Reversal of Fortune The dividend yield on European stocks is now higher than the yield on European government bonds. That makes dividend-paying stocks relatively attractive.

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By williAM MAnn European Investment Strategist Private Client Investment Strategy Citi

europe


While the developed markets’ rally is six months old, emerging markets made their lows 10 months ago. In fact, the

gains of the last month place the MSCI Emerg-ing Markets Index solidly above its level prior to the collapse of Lehman Brothers in September 2008, while developed equity markets are still, on average, 25% below that point.

This pattern of emerging markets outper-forming developed markets is expected. In three of the four bear markets since 1990, not only did emerging market equities bottom in advance of developed markets, but they also outpaced the developed markets and recouped the bear market losses faster. In the current cycle, the MSCI Emerging Markets Index has gained 85% from its October 2008 trough, while the MSCI World Index, a proxy for the developed markets, has gained 27%. Both gains are of a similar magnitude and ratio to previous recoveries.

ReCoRD inFloWs. Strong performance attracts new cash. Year-to-date inflows to emerging market equity funds are at a record

$41 billion. Good earnings prospects help, too. According to IBES estimates, emerging market earnings are expected to grow 33% in 2010 versus 25% for the developed markets. That leg up has changed the valuation picture. Currently the MSCI Emerging Market Index trades at a P/E ratio of 12.3 times the consen-sus forecast for 2010 earnings. That is a slight discount to the 13.7 P/E on the MSCI World Index (see chart).

In our view, emerging markets valuations can go higher for several reasons. These include the integration of their workers into the global economy; rapid growth in both working-age populations and average incomes; development of large, urban consumer markets; and strong demand for infrastructure construction.

neAR-teRm Positive. Our outlook for the emerging markets is positive on a near-term cyclical view as well. Some of the largest emerging markets, specifically Brazil, India and China, are exiting the global financial crisis with stronger financial positions and greater monetary and fiscal policy flexibility than many developed markets. These nations have current-account surpluses, healthier external-debt burdens and real-exchange-rate appreciation. As such, the emerging markets offer the potential for attractive risk-adjusted returns—with greater upside in the event of a vigorous economic recovery. Moreover, because of stronger relative growth, we believe that a cushion exists against downside risk in case of a muted global recovery.

Central bank policy in the emerging markets will be critical. We expect China to be the first major nation to tighten monetary policy. How-ever, since inflation does not pose a near-term risk, neither the Morgan Stanley nor the Citi economics team anticipates a meaningful hike in reserve requirements or a reimposition of lending controls until next year.

Leaving Developed Markets in the Dust

By BArBArA reinhArD, CfA Emerging Markets Strategist Morgan Stanley Smith Barney

Greater expectations Emerging markets profit forecasts are more than keeping up with prices. Thus, the forward price/earnings ratio for the MSCI Emerging Markets Index is less than 90% of the forward P/E for the MSCI World Index.

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Data Source: MSCI Barra, Thomson Reuters, FactSet, Morgan Stanley Smith Barney as of 26 August 2009


emerging markets

s&P/Case-shiller Home Price 20-City index, non-seasonally Adjusted, month-over-month Percent Change

Higher Home Prices, but ...

For two months in a row, the S&P/Case-Shiller Home Price 20-City Index showed month-over-month gains. The June gain, in numbers released on Aug. 25, was up 1.4% on a non-seasonally adjusted basis. May’s num-ber was 0.5%. Eighteen of the 20 cities posted upticks; onlyDetroitandLasvegasrecorded losses.

Josh Levin, housing analyst at Citi Investment Research & Analysis, thinks the worst of the home price declines is past but cautions against getting too excited about an upturn. levin believes a temporary decline in the proportion of distressed sales may be giving the home price index an upward tilt. over the last few months, he

says distressed sales as a percentage of total home sales have come down to 30% from 50%, due to the temporary moratorium on foreclosures.

Levin also notes that the percentage of mortgages in delinquency or foreclosure is at an all-time high. What’s more, the “cure rate”—those that resume regular pay-ments—among delinquent mortgages has declined precipitously, too. These two data points suggest that the pipeline of distressed sales continues to build. Levin says that unless foreclosure moratoriums are made per-manent, these distressed properties will eventually come to market, putting fur-ther downward pressure on home prices.

Quarterly equity issuance for Real estate investment trusts

shoring up the Reits

Global real estate investment trusts have been moving in sync with global equities, with the FTSE EPRA/NAREIT Global Real Estate Index up an impressive 18.5% from July through mid August—this coming atop a 37.3% gain in the second quarter. Still, because of a 24.7% decline in the first quarter of 2009, the index has a net gain of “only” 28.5% for the year to date through Aug. 25.

The much-improved market climate has been helping these landlords shore up their financial foundations. in the sec-ond quarter, global Reits raised $16.6 billion in new equity, the highest since the second quar-ter of 2007. included in

that tally is $14 billion for us Reits, the stron-gest quarter for them in five years. in our view, this new equity has sig-nificantly improved Reit balance sheets and has largely solved the com-panies’ funding issues through 2012.

Of course, this issu-ance has not arrested the decline in the value of the REIT assets. But in our view, the market has already priced in an expected 35% decline in REIT asset values. As such, we believe this asset class is attractive at cur-rent prices and provides an added level of a diversifica-tion to a portfolio of global equities and bonds.

Data Source: Dealogic as of 20 August 2009 Data Source: Citi Investment Research & Analysis, Haver Analytics as of 25 August 2009

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nine siGnPosts FoR 2009

In January, we intro-duced “Nine Signposts for 2009,” indicators to watch for recovery in the markets and the economy. This month, seven show improvement, one shows slight improvement and one shows no appreciable change (see table).

One indicator is the advance-decline line on the S&P 500. It measures the difference between the number of stocks rising and falling within the index. The S&P 500 advance-decline line has gained more than 1500 points in August—and more than 3000 points this year. An increasing advance-decline line is characteristic of a healthy rally.

We also publish “Signposts” updates at mid month. For the most recent copy, contact your Private Banker.

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S&P 500 Index (left scale)

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Data Source: Bloomberg as of 27 August 2009

I = Improvement, SI = Slight Improvement, D=Deterioration, SD=Slight Deterioration

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Data Source: Bloomberg, The Yield Book, Citi Economic & Market Analysis, The Conference Board as of 27 August 2009 or latest possible date

est. Weekly net new Cash Flow to mutual Funds ($ millions)*

Fund investors’ savvy

Conventional wisdom holds that individual inves-tors are late to get into the market after it starts moving up and slow to get out on the downside. But mutual funds—by and large, an investment product for the retail investor—show a different picture. in fact, cash inflows and outflows tend to be correlated with the market, accord-ing to data collected by the investment Company institute (iCi), the mutual fund industry’s major trade association.

The ICI reports posi-tive net new cash flows to mutual funds in each of the 23 weeks ending Aug. 19 (the figures are reported with a one-week lag). What’s significant about that? The

first week in this long run was the one that started March 11, just two days after most major stock market indexes bottomed.

As the market was sinking in the second half of 2008 and the first two months of 2009, investors were pulling out, moving in step with the market. Late last year, net cash flows were negative for 16 weeks straight.

Given investors’ renewed appetite for riskier assets and the atypically low yields on cash, we believe it is likely that they will con-tinue putting money into the funds going forward. That alone reinforces bullish behavior. Managers must invest new inflows, which, in turn, pushes prices higher.

*Excludes money market funds Data Source: Investment Company Institute, Bloomberg as of 26 August 2009

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For several months, the fixed income market has been heralding the start of the recovery. The recession’s exit is evi-

dent in the lower prices and higher yields on US Treasuries and other sovereign debt, along with the significant collapse in corporate spreads. Analysis of the high yield market suggests that even the default rate of change has peaked.

Normally, this might be the point at which investors start debating the magnitude and tim-ing of policy rate hikes. However, in our opin-ion, the central banks will be focusing not on rate hikes but on strategies that will allow them to exit their Quantitative Ease (QE) programs. With respect to the US Federal Reserve, we still don’t see it raising fed funds until the second quarter of 2010. In fact, the Fed policymakers continue to emphasize their belief that “eco-nomic conditions are likely to warrant excep-tionally low levels of the federal funds rate for an extended period.”

BACkinG oFF. The QE retreat is underway. At the August Federal Open Market Committee meeting, the Fed began the “weaning” process for the markets with respect to their Treasury purchases. With only a little more than $30 billion left in their stated $300 billion goal, the policymakers decided to push the end date back a month, to the end of October. In this way, the

Fed seeks “to promote a smooth transition” in the market as these purchases wind down.

On the global front, the possibility exists that some further QE could be in store, as illustrated by the Bank of England’s recent decision to increase the size of its existing programs. It also seems plausible that policymakers in Central Europe could implement another rate cut. In the Euro Zone, the European Central Bank (ECB) seems to view its current policy as appro-priate and will remain on hold, but given com-ments from ECB President Jean-Claude Trichet, the ECB could chart its own course by raising rates before unwinding its QE measures.

While there is no expectation for an outright rate hike in China until mid 2010, there is spec-ulation that the People’s Bank of China could tighten policy by raising reserve requirements. Whether by a rate hike or through boosting the reserve requirement, either move by the central bank would mark the advent of tightening.

HiGHeR soveReiGn YielDs. Since reach-ing their low points in December, longer-term sovereign yields have been climbing. In our view, these yields can go higher in coming months, due to heightened expectations of inflation toward the end of the year and the continued unwinding of the “risk aversion trade”—selling government debt to buy riskier assets. Both Citi and Morgan Stanley forecasts are for progressively higher yields through the end of 2010 (see table).

BeniGn inFlAtion. The market’s percep-tion of a benign inflation environment in the US and Europe can be seen in 10-year break-even spreads, the yield difference between the 10-year developed country sovereign debt and the 10-year inflation-indexed bond. In the US, inflation-indexed bonds are known as TIPS. Essentially, the lower the break-even spread, the lower the perception of inflation. The 10-year break-even spread for TIPS is about 1.77%;

Global Central Banks: Exit Stage Right?

Yield Forecasts for 10-Year Government Bonds

Current December 2009 June 2010 December 2010

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Morgan Stanley

US 3.42% 3.80% 4.10% 4.10% 5.00% 4.20% 5.50%

Euro Zone

3.23% 3.60% 4.00% 3.70% 4.25% 3.90% 4.75%

UK 3.53% 4.16% 4.60% 4.55% 5.10% 4.84% 5.30%

Japan 1.30% 1.40% 1.20% 1.50% 1.40% 1.60% 1.50%

Data Source: Citi Economic & Market Analysis, Morgan Stanley Economics as of 27 August 2009

By Kevin flAnAgAn Senior Fixed Income Strategist Morgan Stanley Smith Barney

By JonAthAn MACKAySenior Fixed Income Strategist Morgan Stanley Smith Barney

Fixed income


this is up considerably over the past six months but still relatively cheap compared with the 2.2% average of the last five years. Assum-ing inflation in the US averages above 1.77% during the life of the security, 10-year TIPS are attractive. Break-even rates on 10-year UK and German inflation-linked bonds, 2.28% and 1.81%, respectively, are also attractive relative to long-term averages. That said, we have a neutral exposure to inflation-linked securities due to our expectation for only a moderately higher infla-tion environment over the next 12 months.

unPReCeDenteD CReDit RAllY. The cur-rent rally in US and European high-grade and high yield corporate bonds has been remarkable. In the US the year-to-date duration-adjusted returns—that is, the total return minus Treasury returns—for the Citi BIG Corporate Index is roughly 17%, while the Citi High Yield Index has already crossed the 40% mark. These returns are more than three times the duration-adjusted returns in the 2002 to 2003 and 1991 to 1992 post-recession cycles.

The market also seems to have a better handle on high yield defaults, as the bulk of the defaults are likely behind us. Going forward, the quarterly default rate will probably drop fairly quickly. Ironically, the rate may drop not because these issuers are so much healthier but because we have run out of large bankruptcy candidates. Although we expect the 12-month moving average of the default rate to continue rising through the end of this year, it will likely drop fairly quickly in 2010 as each of the last three quarters of 2009 drops from the count.

WHeRe to FRom HeRe? Recently, we have started to see the positive correlation between equities and credit fraying at the edges, as the S&P 500 continues to hit new highs for the year and credit has been losing ground. Granted, the rally in both high yield and high grade started almost three months earlier than the equity rally,

so perhaps a little credit market fatigue is setting in. September and October will be interesting months for the credit markets; we may see some weakness depending on supply, earnings and economic data. However, we believe any weak-ness will be short-lived, as investors likely will reset positions going into the year’s end.

Spreads in both asset classes are still wide of long-term averages. The Citi BIG Corporate Bond index is now trading with an option-adjusted spread over Treasuries of about 228 basis points, down from a peak of 629 basis points last December. In high yield, the spread to worst on the Citi High Yield Market Index is 852 basis points, down from a peak of 1818. We believe spreads in both US and European corporate debt will continue to tighten over the next 12 months, albeit not at the same pace as the last six. We maintain our overweight stance on high grade and believe improving fundamen-tals and continued strong technical trends could push high-grade spreads closer to long-term averages. We cannot rule out the possibility of a correction in high yield in the short term; but, for investors with longer time horizons, we believe there is value in the high yield sector and have moved to a slight overweight position.

emeRGinG mARkets DeBt nARRoWs. Spreads on emerging market sovereign bonds narrowed significantly. The option-adjusted spread on the Citi Global Emerging Markets Sovereign Bond Index is around 354 basis points, down from 810 basis points in De-cember. The long-term average for the index is roughly 520 basis points. However, we note that spreads in this sector have been trending lower during the past several years, reflecting a growing proportion of investment-grade issuers. Thus, we have a neutral stance on emerging market sovereign debt. Concurrently, we also see limited downside risks to this sector as the global recovery gains traction.


At A GlAnCe

Global Alternative/Absolute Return Investments

RelAtive WeiGHt WitHin AlteRnAtive investments BenCHmARk inDex

REITS OVERWEIGHT FTSE EPRA/NAREIT Developed Total Return

Commodities OVERWEIGHT Dow Jones/UBS

Inflation-Linked Securities NEUTRAL Barclays Capital Global Inflation-Linked

Managed Futures NEUTRAL CISDM CTA Asset-Weighted

investment outlook The following table summarizes the tactical asset allocations of the Global Investment Committee, which is made up of senior professionals from Morgan Stanley & Co. Incorporated Research, Morgan Stanley Smith Barney, Citi Investment Research & Analysis and outside financial market experts. These tactical allocations represent short-term deviations from the baseline strategic allocations, which are the blends of asset classes the committee believes are best suited, over the long run, for achieving maximum returns for various levels of risk tolerance. vis-à-visthestrategicallocation:Overweightmeansupto10percentagepointsgreater;neutralmeansinlinewiththestrategicallocation; and, Underweight means up to 10 percentage points below.

RelAtive WeiGHt BenCHmARk inDex

Global Cash UNDERWEIGHT Three-Month LIBOR

Global Bonds UNDERWEIGHT Barclays Capital Multiverse (hedged)

Global Equities OVERWEIGHT MSCI All Country World Investable Market

Global Alternative/Absolute Return Investments

OVERWEIGHT

Global EquitiesRelAtive WeiGHt WitHin eQuities BenCHmARk inDex

Developed Market Large & Mid Cap UNDERWEIGHT

MSCI World

US Large UNDERWEIGHT MSCI USA Large Cap

US Mid OVERWEIGHT MSCI USA Mid Cap

Canada OVERWEIGHT MSCI Canada

Europe UNDERWEIGHT MSCI Europe

Japan UNDERWEIGHT MSCI Japan

Asia Pacific ex Japan OVERWEIGHT MSCI Pacific ex Japan

US Small Cap OVERWEIGHT MSCI USA Small Cap

World ex US Small Cap NEUTRAL MSCI World ex US Small Cap

Emerging Markets OVERWEIGHT MSCI Emerging Markets Investable Market

Global BondsRelAtive WeiGHt WitHin BonDs BenCHmARk inDex

Investment Grade OVERWEIGHT Barclays Capital Global Aggregate

Short Duration UNDERWEIGHT Barclays Capital Global Government 1–3 Year

Government/ Government-Related

UNDERWEIGHT Barclays Capital Global Government and Government Related

Corporate & Securitized OVERWEIGHT Barclays Capital Global Corporate and Global Securitized

High Yield OVERWEIGHT Barclays Capital Global High Yield

Emerging Markets NEUTRAL Barclays Capital Global Emerging Markets

ForecastsGDP GRoWtH Citi

moRGAn stAnleY

US

2009 -2.7% -2.6%

2010 2.5% 2.6%

Euro Zone

2009 -4.0% -4.0%

2010 1.0% 0.6%

Japan

2009 -5.3% -5.5%

2010 0.8% 0.7%

UK

2009 -4.4% -4.2%

2010 1.3% 1.3%

Developing Economies

2009 0.6% 1.4%

2010 5.3% 5.7%

inFlAtion CitimoRGAn stAnleY

US

2009 -0.5% -0.4%

2010 1.2% 2.1%

Euro Zone

2009 0.2% 0.4%

2010 1.3% 1.3%

Japan

2009 -1.2% -1.2%

2010 -1.0% -0.6%

UK

2009 2.0% 1.8%

2010 2.9% 2.5%

Developing Economies

2009 4.5% 4.1%

2010 5.2% 4.7%

Monetary Policy

US Both firms expect rates to remain at 0.00% to 0.25% through 2009 and increase to 0.50% in 2010’s second quarter.

Euro Zone Both firms see rates steady at 1.00% in 2009. Citi expects that rate to continue through the second quarter of 2010 while Morgan Stanley forecasts an increase to 1.25% by mid 2010.

Japan Citi forecasts today’s 0.10% rate to remain steady through 2010’s second quarter. Morgan Stanley expects a drop to 0.05% in the fourth quarter that will be in place through 2010’s second quarter.

UK Both firms see today’s 0.50% to remain in place through the fourth quarter. Citi expects that rate to continue through the second quarter of next year, while Morgan Stanley anticipates an increase to 1.75% at that time.

Currencies

Developed economy currencies are likely to trade in a tight range. The biggest currency movements in the quarters ahead are likely to feature many emerging market curren-cies, particularly in Asia, appre-ciating relative to developed market currencies.

At a Glance


Rising commodity prices are back. Just as the global equity market indexes formed a bottom in March 2009, global

commodity prices troughed too, albeit a few weeks earlier. Consistent with our view that a global recovery is underway, we have a positive view on commodities, especially the energy complex. We hold this positive view for cyclical and for structural reasons.

tHe CYCle vieW. The cyclical view has been playing out for six months. Since early March, commodity prices, as measured by the S&P GSCI Total Return Index, have gained 36%. However, we think there is more to the story.

The recession that gripped the global economy was not just a reaction to the credit crisis that started in the US; in our opinion, it was also a response to the doubling of commod-ity prices in 2007 and the first half of 2008. As prices climbed, both consumers and commercial users had difficulty digesting the rising costs, which ultimately eroded discretionary spend-

ing and depressed industrial activity. Just as the run-up in prices has been an underappreciated catalyst that tipped the world into recession, the collapse in commodity prices has been an underappreciated source of stimulus. Indeed, cheap commodity prices are also a stimulant of demand. While US consumers would not argue that the average price of $2.63 per gallon for gasoline is cheap, it is still significantly cheaper than the $4.11 peak in July 2008. That year-over-year decline should, on the margin, lead to greater demand.

suPPlY ConstRAints. The structural view for commodity prices focuses on supply constraints. During the past 10 years, much available capital went into real estate and domes-tic consumption, leaving many natural-resource projects underfunded. The result was a failure to add enough production capacity, leaving many resource industries supply-constrained. This is especially problematic for energy, as much of the potential increase in capacity is located in politi-cally unstable areas of the world.

RoBust GRoWtH. What lies ahead? Fast-growing emerging market economies such as China and India are key. According to the Energy Information Administration, per capita worldwide energy consumption over the 10 years that ended in 2006—the latest available data—increased by 11% (see table). However, consumption growth in the emerging markets was far stronger—up 93% in China, 34% in the Middle East and 14% in Latin America. Given the size of the populations in these regions, an increase in per capita demand implies massive volume increases required in commodities as urbanization and consumer wealth grow. Given the global recovery on the way and ongoing sup-ply constraints, we believe that commodities in general and the energy complex in particular—that is, crude oil, heating oil, gasoline, natural gas and coal—are likely to move higher.

Supply Constraints Meet Rising Global Demand

Per Capita total Primary energy Consumption, 1980 to 2006

% Change

1980 1990 1996 2006 1980 to 2006

1996 to 2006

Canada 394 396 418 427 8 2

US 343 338 349 335 -2 -4

UK 157 161 171 162 3 -6

Europe 135 137 139 146 8 5

Japan 130 152 170 179 37 5

Middle East 62 84 95 127 104 34

Latin America 40 41 47 53 35 14

China 18 24 29 56 220 93

Africa 14 15 15 16 10 6

India 7 12 17 18 144 3

World 64 66 65 72 14 11

Data Source: Energy Information Administration as of 30 July 2009

By BArBArA reinhArD, CfA Emerging Markets Strategist Morgan Stanley Smith Barney

Commodities


Following one of the best half-year performances on record, hedge funds continued to make gains in July. The

HFRX Global Hedge Fund Index returned 1.6% during the month, bringing year-to-date performance to 7.3%. Each of the major styles generated positive returns in July, according to Hedge Fund Research. What’s more, this year’s average monthly returns are higher than the average returns going back to 1990 (see chart).

For sure, part of the returns can be attributed to investors returning to risky assets such as equity, credit and commodities. Next, greater dispersion among individual securities provided opportunities for active managers to generate better returns through security selection. Finally, the industry shakeout during late 2008 and early 2009, coupled with the banking industry’s decline in proprietary trading, has significantly reduced competition. This has created attractive opportunities for the surviving hedge funds.

inneR stRenGtH. The organizational strength of hedge funds also has improved. Notably, the decline in assets under management

that began in mid 2008 has been decelerating; net outflows declined from $103 billion in the first quarter of 2009 to $42 billion in the second quarter. With performance gains, assets under management actually increased by $100 billion in the second quarter, an increase of roughly 7.5%, according to Hedge Fund Research. In fact, we expect that hedge fund net flows will be positive in the third quarter.

Additionally, some hedge funds have exceed-ed their previous high-water marks. According to an estimate by Morgan Stanley Prime Broker-age Research, more than 20% of hedge funds have made back losses suffered in 2008. This alleviates concerns that many fund management companies would not be able to retain employ-ees as revenues declined. While some funds will continue to operate under organizationally stressful conditions, our view is that these risks have dissipated.

We expect that industry consolidation is apt to provide managers with the opportunity to generate so-called alpha, excess returns based on skill rather than market performance. In our view, investors should diversify their hedge fund portfolios across a range of styles and managers, ensure that market exposure is tightly controlled and exchange some portion of potential upside to protect against possible economic shocks.

stRAteGiC emPHAsis. We continue to advocate strategies that may benefit from volatility as the global recovery might have fits and starts that result in episodic market volatility. We also favor equity hedge manag-ers with lower net exposures, since the alpha opportunities there are compelling. Finally, we recommend distressed securities strategies, as they represent a multiyear opportunity that is likely to be rewarding. Rui de Figueiredo is a consultant who is an associate professor at the Haas School of Business, University of California at Berkeley.

Building Onto Record Returns

Above the norm Average hedge fund returns in the first seven months of 2009 are mostly above their 1990 to 2008 monthly average. Of the broad categories of hedge funds, only macro funds are having a below-average year.

0% 1% 2% 3%

Jan. to July 2009

Jan. 1990 to Dec. 2008Fund-Weighted

Composite

Fund of FundComposite

Relative Value

Macro

Event Driven

EquityHedge

Data Source: Hedge Fund Research as of 31 July 2009

By rui De figueireDo Portfolio Solutions Group Morgan Stanley Alternative Investment Partners

Hedge Funds


STANDARD & POOR’S 500 INDEX Widely regarded as the best single gauge of the US equities market, this capitalization-weighted index includes a representa-tive sample of 500 leading companies in leading industries of the US economy. Although the S&P 500 focuses on the large-cap segment of the market, with over 80% coverage of US equities, it is also a useful proxy for the total market.

STANDARD & POOR’S CONSUMER DISCRETIONARY INDEX The index repre-sents the consumer discretionary portion of the S&P 500. It includes stocks from such industries as automobiles and components, consumer durables, apparel, hotels, restaurants, leisure, media and retailing.

MSCI ALL COUNTRY WORLD INDEX This index represents 48 developed and de-veloping equity markets. Index components are weighted by market capitalization.

MSCI EMERGING MARKETS INDEX This is a free-float-adjusted market- capitalization-weighted index that is designed to measure equity market perfor-mance of 22 emerging markets.

MSCI WORLD INDEX: This index is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of 23 developed-country markets.

FTSE EPRA/NAREIT GLOBAL REAL ESTATE INDEX The index has diverse representation of publicly traded equity REITs and listed property companies glob-ally. Stocks in the index are free-float weighted to ensure that only the investable equities are included.

KOREA COMPOSITE STOCK PRICE INDEX This is a capitalization-weighted index ofallcommonsharesonthekoreanStockExchanges.

BALTIC DRY INDEX The Baltic Dry Index measures rates on 26 shipping routes for vessels of different sizes.

CITI FINANCIAL CONDITIONS INDEX This proprietary index uses corporate credit spreads, the money supply, equity values, mortgage rates, energy prices and the value of the dollar to gauge the likely impact of financial conditions on economic activity.

CITIGROUP HIGH GRADE BOND INDEX This index includes investment-grade bond issues with maturities of at least 10 years.

CITIGROUP HIGH YIELD MARKET INDEX This index includes cash-pay, deferred-interest and Rule 144A bonds with remaining maturities of at least one year and a minimum amount outstanding of $100 million. The issuers are domiciled in the US or Canada.

CITIGROUP BIG CORPORATE INDEX This index includes investment-grade US and non-US corporate fixed income securities.

BARCLAYS CAPITAL MULTIVERSE INDEX This provides a broad-based measure of the global fixed income bond market. The index represents the union of the Global Aggregate Index and the Global High Yield Index and captures investment-grade and high-yield securities in all eligible currencies.

BARCLAYS CAPITAL GLOBAL AGGREGATE INDEX This index provides a broad-based measure of the global investment-grade, fixed-rate debt markets.

BARCLAYS CAPITAL GLOBAL GOVERNMENT 1-3 YEAR INDEX This index tracks fixed-rate local currency short-term sovereign debt of investment-grade countries.

BARCLAYS CAPITAL GLOBAL GOVERNMENT AND GOVERNMENT-RELATED INDEX This index contains the government and government-related portion of the Multiverse Index.

BARCLAYS CAPITAL GLOBAL CORPORATE AND GLOBAL SECURITIZED INDEX This index is a broad-based measure of the global investment-grade, fixed-rate corporate debt markets as well as the securitized component that includes mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities.

BARCLAYS CAPITAL GLOBAL HIGH YIELD INDEX This index provides a broad-based measure of the global high yield fixed income markets. It is also a compo-nent of the Multiverse Index and the Global Aggregate Index.

BARCLAYS CAPITAL GLOBAL EMERGING MARKETS INDEX This index consists of the fixed- and floating-rate US dollar-denominated US Emerging Markets Index and the primarily euro- and sterling-denominated fixed-rate Pan-European Emerg-ing Markets Index and includes emerging markets debt from the Americas, Europe, Asia, Middle East and Africa. For the index, an emerging market is defined as any country that has a long-term foreign currency debt sovereign rating of Baa1/BBB+/BBB+ or below using the middle rating of Moody’s, S&P and Fitch.

MSCI USA LARGE CAP This free-float adjusted capitalization-weighted index consists of the 300 largest US stocks by market cap.

MSCI USA MID CAP This free-float adjusted capitalization-weighted index consists of the next 450 largest US stocks by market cap.

MSCI CANADA This free-float adjusted capitalization-weighted index is designed to measure the performance of Canada-based equities.

MSCI EUROPE This free-float adjusted capitalization-weighted index is designed to measure the performance of 16 developed European markets.

MSCI JAPAN This free-float adjusted capitalization-weighted index is designed to measure the performance of Japanese equities.

MSCI PACIFIC EX JAPAN This free-float adjusted capitalization-weighted is designedtomeasuretheperformanceofequitiesinaustralia,Hongkong,newZealand and Singapore.

MSCI USA SMALL CAP This free-float adjusted capitalization-weighted index consists of over 2000 of the smallest US companies by market capitalization.

MSCI WORLD EX US SMALL CAP This free-float adjusted capitalization-weighted index consists of the small cap world index ex the US portion.

FTSE EPRA/NAREIT DEVELOPED MARKET REAL ESTATE INDEX The index has diverse representation of publicly traded equity REITs and listed property compa-nies in global developed markets. Stocks in the index are free-float weighted to ensure that only the investable equities are included.

DOW JONES-UBS COMMODITY INDEX This index comprises futures contracts on physical commodities. These include energy, base metals, precious metals and agricultural commodities.

BARCLAYS CAPITAL GLOBAL INFLATION-LINKED INDEX This index includes sovereign bonds with cash flows linked to an inflation index. Issuer countries includetheUS,Uk,Canada,Sweden,italy,Germany,Greece,FranceandJapan.Bonds must also be denominated in the issuer’s currency and have a maturity greater than one year.

CISDM CTA ASSET WEIGHTED This index of strategies practiced by commod-ity trading advisors is published by the Center for International Securities and Derivatives Markets.

S&P/GSCI GLOBAL TOTAL RETURN INDEX This S&P/GSCI index measures market performance of 24 futures contracts covering the energy, metals and agricultural sectors. The total return index tracks the S&P/GSCI plus the Treasury bill rate that can be earned on funds committed to trading the contracts.

HFRX GLOBAL HEDGE FUND INDEX This index is designed to be representative of the overall composition of the hedge fund universe. It comprises all eligible hedge fund strategies including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbi-trage and relative value arbitrage. The strategies are asset-weighted based on the distribution of assets in the hedge fund industry.

HFRX EQUITY HEDGE INDEX This is an index of equity hedge strategies. They maintain positions both long and short in primarily equity and equity-derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strat-egies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios.

HFRX DISTRESSED SECURITIES INDEX These strategies focus mainly on corporate credit instruments of companies trading at significant discounts to par value as a result of either formal bankruptcy proceedings or financial market expectations of near-term proceedings.

HFRX EVENT DRIVEN This is an index of strategies that maintain positions in companies currently or prospectively involved in a wide variety of corporate transactions including but not limited to mergers, restructurings, financial dis-tress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company-specific developments. Investment theses are typically predicated on fundamental char-acteristics (as opposed to quantitative), with the realization of the thesis predicat-ed on a specific development exogenous to the existing capital structure.

HFRX MACRO INDEX Macro strategy managers trade a broad range of strate-gies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, currency and commodity markets. Managers employ a variety of techniques: both dis-cretionary and systematic analyses, combinations of top-down and bottom-up theses, quantitative and fundamental approaches, and long- and short-term holding periods.

HFRI FUND-WEIGHTED COMPOSITE INDEX This index includes returns from a diverse sample of more than 2000 hedge funds with at least $50 million in assets or that have been actively trading for at least 12 months. The returns are equal-weighted.

HFRI FUND OF FUNDS COMPOSITE INDEX This index incorporates returns from some 800 funds of funds that have at least $50 million in asset or that have been actively trading for at least 12 months. The returns are equal-rated.

HFRX RELATIVE VALUE ARBITRAGE INDEX These strategies maintain posi-tions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment the-ses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager.

index Definitions (in order of appearance)


(2654)

UNITED KINGDOMLondon44-207-508-8000

UNITED STATESAtlanta, GA877-248-4418Beverly Hills, CA800-870-1073Boston, MA800-870-1073Chicago, IL800-870-1073Denver, CO800-870-1073Greenwich, CT800-870-1073Honolulu, HI800-870-1073Houston, TX800-870-1073 (US)713-966-5102 (Int’l)Los Angeles, CA800-870-1073Miami, FL800-870-1073305-347-1800 (Int’l)

AUSTRALIAMelbourne61-3-8643-9988Sydney61-2-8225-4284

BAHAMASNassau242-302-8706

BRAZILPorto Alegre55-51-4009-8811Rio de Janeiro55-21-4009-8161Sao Paulo55-11-4009-3432

CANADAMontreal514-393-7526Toronto416-947-5300Vancouver604-739-6222

CAYMAN ISLANDSGrand Cayman345-949-0355

CHANNEL ISLANDSSt. Helier, Jersey44-1534-608-010

GREECEAthens30-210-675-6850

HONG KONGHong Kong852-2868-8688

INDIABangalore91-80-4144-6389Mumbai91-22-4001-5282New Delhi91-124-418-6698

INDONESIAJakarta62-21-5290-8065

ISRAELTel Aviv972-3-684-2588

ITALYMilan39-02-864-741Rome39-06-421-781

KINGDOM OF BAHRAINKingdom of Bahrain973-17-586-287

KOREASeoul82-2-2124-3600

MEXICOMexico City52-55-22-26-8310Monterrey52-81-1226-9401

MONACOMonte Carlo377-9797-5010

PORTUGALLisbon351-21-316-8400

SINGAPORESingapore65-6227-9188

SPAIN34-93-316-5400Madrid34-91-538-4400Valencia96-353-51-47

SWITZERLANDGeneva & Zurich41-58-750-5000

TAIWANTaipei886-2-7718-8608

THAILANDBangkok66-2-232-3031

UNITED ARAB EMIRATESAbu Dhabi971-2-678-2727Dubai971-4-604-4411

New York, NY800-870-1073 (HNW & LFG)212-559-9067 (Int’l)212-559-9155 (LatAm)Orange County, CA800-870-1073Palm Beach, FL800-870-1073Palo Alto, CA800-870-1073Philadelphia, PA800-870-1073Phoenix, AZ800-870-1073San Francisco, CA800-870-1073Seattle, WA800-870-1073Short Hills, NJ800-870-1073Uniondale, NY800-870-1073Washington, DC800-870-1073 (HNW)202-220-3636 (LFG)

For archives of The View, The View Online and The View Up Close, please visit the Citi Private Bank client Web site at www.citiprivatebank.com.

If you have questions or comments, please write to [email protected].

The views expressed in this presentation are those of the authors and do not necessarily reflect the views of Citi Private Bank or its affiliates. Morgan Stanley Smith Barney LLC is a sepa-rate investment advisor and broker/dealer registered with the Securities and Exchange Commission, and is affiliated with, but distinct from, Citibank and Citigroup Global Markets Inc.

All expressions of opinion are subject to change without notice and are not intended to be a guarantee of future events. This document is for information only and does not constitute a solicitation to buy or sell securities. Opinions expressed herein may differ from the opinions expressed by other businesses of Citigroup Inc., are not intended to be a forecast of future events or a guarantee of future results or investment advice and are subject to change based on market and other conditions. Past performance is not a guarantee of future results. Although information in this document has been obtained from sources believed to be reliable, Citigroup Inc. and its affiliates do not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. Throughout this publication where charts indicate that a third party (parties) is the source, please note that the source references the raw data received from such parties.

Citi Private Bank is a business of Citigroup Inc. (“Citigroup”), which provides its clients access to a broad array of products and services available through bank and nonbank affiliates of Citigroup Inc. Not all products and services are provided by all affiliates or are available at all locations. In the US, brokerage products and services are provided by Citigroup Global Markets Inc. (“CGMI”), Member SIPC. CGMI and Citibank, N.A. are affiliated companies under the common control of Citigroup Inc. Outside the US, brokerage services will be provided by other Citigroup Inc. affiliates. Citi and Citi with Arc Design are trademarks and service marks of Citigroup Inc. and its affiliates and are used and registered throughout the world.

In the UK, certain services are available through Citibank, N.A. (“Citibank”) and Citibank International PLC, 33 Canada Square, Canary Wharf, London E14 5LB, which is authorized and regulated by the Financial Services Authority for the conduct of investment business in the UK and is a subsidiary of Citigroup Inc., USA.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.

Alternative investments referenced in this report 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 the fund, potential lack of diversification, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and advisor risk.

Asset allocation does not assure a profit or protect against a loss in declining financial markets.

The indexes 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 invest-ment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results.

International investing entails greater risk, as well as greater potential rewards compared to US 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 economics.

Investing in smaller companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and il-liquidity.

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.

© Copyright 2009, Morgan Stanley Smith Barney LLC. Member SIPC.

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