aug.

8, 2011
market commentary global investment committee

Global Investment Committee Special Bulletin

analysis authors

Impact of US Credit Downgrade on Markets

The downgrade of US long-term debt by Standard and Poors, which is notable politically and historically, is having a prompt and negative shortterm effect on global financial markets. However, the next stop is not a recessionnor is it a drop in corporate profits. This a split decision on ratings, as the other two major ratings agencies, Moodys and Fitch, have maintained their respective top-drawer ratings for US debt. As this latest sell-off abates, expect the markets to refocus on the fundamentals: an intact global business-cycle expansion that,

jeff applegate

Chief Investment Officer

david m. darst, cfa john m. dillon

Chief Investment Strategist Chief Municipal Bond Strategist

kevin flanagan elizabeth lynn

Chief Fixed Income Strategist Emerging Markets Equity Strategist

jonathan mackay

Senior Fixed Income Strategist

charles reinhard

Deputy Chief Investment Officer

market commentary / global investment committee

in our view, should deliver double-digit profit-growth into 2012. Our base case remains that a US economic rebound will occur in the second half of this year and that European policymakers will eventually be forced to take more decisive action to stabilize their debt markets and the euro.

fiscal headwinds will emerge next year, which will put added pressure on the Federal Reserve to become even more stimulative.

Implications for Global Policy

Impact of Downgrade on US Economic Policy

Tom Gallagher*, our public policy expert and a Global Investment Committee member, thinks that it will take more than a downgrade to change the extreme partisan polarization in Washington, as evidenced by the initial blame game reaction. A better measure of the downgrades impact on politics will come on Aug. 16, the deadline for appointments to the special congressional committee charged with coming up with $1.2 trillion to $1.5 trillion in deficit reduction over the next 10 years. The Democratic and Republican leaders in both chambers will each choose three members of the 12-person committee. While there is widespread expectation in Washington that this special committee process will deadlock, the appointment of moderates open to compromise would be a sign that some kind of bipartisan agreement on entitlements and taxes is possible. Among the Senate members, any selection drawn from the Gang of Six, which produced a widely praised centrist deficit-reduction package, would be a positive sign. The gang members are Senators Saxby Chambliss (R-Ga.), Tom Coburn (R-Okla.), Kent Conrad (D-N.D.), Mike Crapo (R-Idaho), Dick Durbin (D-Ill.) and Mark Warner (D-Va.). The downgrade reduces the already low odds of enacting a free-standing economic stimulus bill to close to zero. Under current law, the expiration of tax cuts at the end of this year, state and local cutbacks, and the unwinding of the 2009 stimulus bill combine to shift near-term fiscal policy from a small tailwind this year to a serious headwind next year. President Obama wants to extend the expiring payroll tax cut among other measures to offset this headwind, but the only realistic chance for such measures will be as part of a broader long-term deficit reduction measure, which is the special committees task. Even then, the downgrade will shift the emphasis further toward longer-term deficit reduction and away from near-term stimulus. The more likely meaningful

In response to the US ratings downgrade and the ongoing stresses in the European sovereign bond market, G-7 finance ministers and central bank governors pledged in a statement to take all necessary measures to support financial stability and economic growth. The G-7 policymakers have committed to consult closely and take coordinated action where needed. The G-20 issued a similar statement, and the European Central Bank has already begun to buy Spanish and Italian government bonds.

Implications for Equity Markets

We view the downgrade as a manageable short-term negative for equities. The downgrade was reasonably well-telegraphed during the past few weeks and does little to change what matters most to markets: economic and earnings growth. Additional short-term market volatility could raise equity risk premiums slightly, contributing to modest contraction in the markets price/earnings multiple. However, with multiples already roughly two-to-three points below historical norms adjusted for the current inflation and interest rates, multiples are unlikely to fall very much. This makes equity valuations attractive. Parsing equities between the emerging markets (EM) and the developed markets (DM), the EM fundamentals are relatively stronger. Additionally, Morgan Stanley Economics believes that inflation is likely to peak in the current quarter and that the region is nearing the end of its monetary tightening cycle. As such, we see the end of policy tightening and lower inflation as a secondhalf positive catalyst for P/E multiple expansion from the current below-average level. At 9.7 times forward 12-month earnings, EM equities look very attractive, trading at a 24% discount relative to their history and a 10% discount to DM equities.

Implications for Fixed Income Markets

The possibility for a downgrade on US debt had been well telegraphed by the S&P and should not come as a great surprise to the fixed income markets. Concurrently,

*Mr. Gallagher is not an employee of Morgan Stanley Smith Barney. He is a paid consultant and a member of the Global Investment Committee. His opinions are solely his own and may not necessarily reflect those of Morgan Stanley Smith Barney or its affiliates.

morgan stanley smith barney | aug. 8, 2011

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

market commentary / global investment committee

S&P affirmed its rating on US short-term debt obligation at A-1+. Obviously, the downgrade places the money and bond markets in unchartered territory. In combination with continued stress in Europe, heightened volatility should be expected. The US dollar could also come under near- term pressure. However, the dollar remains the global reserve currency with no real alternative. This has been borne out by initial comments from various foreign official buyers of US Treasuries. The Federal Reserve responded to the downgrade by recommending that risk weightings for US Treasuries remain unchanged; in other words, there will be no additional capital charge for banks holding Treasuries. This should limit any negative impact that might have otherwise occurred in short-term funding markets and thus should help maintain market liquidity. We have seen a slight rise in short-term funding indicators, such as LIBOR-OIS, over the past couple of weeks, but we see that as more indicative of weak economic data and European sovereign debt issues rather than concern over the possibility of a US downgrade. In response to the downgrade, the US Treasury yield curve could steepen, partially reversing the powerful curve-flattening rally that got underway in early July. Prior rating agency pronouncements provided a snapshot of what to expect, as rates moved up along the yield curve, with the 30-year bonds perhaps feeling the most impact. Initially, interest rates on longer-term bonds could rise 25 to 50 basis points, but we expect the market to refocus on the slower pace of economic growth and ongoing flight to quality. In fact, the initial market reaction to the downgrade underscored this point as bond prices rose and yields declined. In the credit markets, we expect spreads to widen in response to the downgrade, more so in high yield. Currently, the option-adjusted spreads on the Barclays Capital US Aggregate Credit Corporate Investment Grade and High Yield Indexes are 156 basis points and 602 basis points, respectively. We continue to recommend a cautious approach and advocate adding exposure on market dips, preferring BBB credits to A and AA nonfinancials. We also like the seven-to-10-year maturity range given the additional yield versus shorter maturity corporates. In high yield, we prefer higher-quality credits in BB over B and CCC issues. Finally, given the sectors relatively flat

yield curve, we prefer shorter duration securities. Trends in emerging market versus developed-market debt provide an especially striking contrast. During the last 12 yearsexcluding the brief period corresponding to the 2008-to-2009 financial crisisEM countries have been consistently upgraded by ratings agencies in the aggregate to BBB from BB. That had been also largely mirrored by spread levels overall. Since 2009, however, spreads have not followed the improvement in credit fundamentals, suggesting that EM bonds are actually trading wide of fair value and of the improvement in EM fundamentals, according to Morgan Stanleys Emerging Markets Fixed Income Strategy team. Currently, more than half of the countries in the Citi Global Emerging Markets Sovereign Bond Index are solidly anchored in the investment-grade category; recent upgrades include Brazil, Columbia, Panama and Uruguay. Moreover, the team notes that while EM countries have significantly lower credit ratings than their DM counterparts, the euro periphery aside, spreads on credit default swaps are often higher for the developed markets.

Implications for Municipal Bonds

The US rating downgrade may impact the municipal bond market, but the implications should be manageable for the marketplace and issuers. In the near term, direct dependency upon the sovereign rating will likely impact the S&P ratings of all related municipal securities. We expect some clarity on this soon. These affected bonds would include pre-refunded bonds, escrowed-to-maturity bonds and any other securities that are backed by the federal government, such as housing bonds that are collateralized by Ginnie Mae, Fannie Mae or Freddie Mac. While absolute yield levels for the aforementioned types of securities will likely continue to hinge upon prevailing US Treasury yields, municipals yield relationship to Treasuries are unlikely to change materially once the initial market reaction to the downgrade passes. Any outsized upward moves in directly related municipal yields should be viewed as an opportunity to acquire what are still the strongest bonds available in the marketplace. The longer-term impact on muni bonds will depend on the execution of federal deficit reduction, especially changes that may significantly alter the level of federal monies available for health, education and other programs

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

morgan stanley smith barney | aug. 8, 2011

market commentary / global investment committee

that are currently administered by the states. Logically, there would be a trickle-down effect that could impact counties and cities, too. Tax reform may also play a significant role. While there is no question that a lower level of government appropriations would be a negative factor, state and local governments have been cutting spending for

years and will do so as needed. Thus, we expect that well-managed, high-quality issuers will very likely continue to maintain their solid market standings; any initial market reaction to the contrary should be viewed as buying opportunities. Our preference for bonds rated A and higher in the six-to-14-year maturity range remains unchanged.

morgan stanley smith barney | aug. 8, 2011

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

Index Definitions
BARCLAYS CAPITAL US AGGREGATE CREDIT CORPORATE INVESTMENT GRADE INDEX This index represents securities that are investment grade, SEC-registered, taxable and dollar denominated. BARCLAYS CAPITAL US AGGREGATE CREDIT CORPORATE HIGH YIELD INDEX The index includes publicly issued US-dollar-denominated non-investment grade, fixed-rate, taxable corporate bonds that have a remaining maturity of at least one year, are rated high yield using the middle rating of Moodys, S&P and Fitch, respectively, and have $600 million or more of outstanding face value. CITI GLOBAL EMERGING MARKETS SOVEREIGN BOND INDEX This index includes Brady bonds and US dollar-denominated emerging market sovereign debt issued in the global, Yankee and eurodollar markets, excluding loans.

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morgan stanley smith barney | aug. 8, 2011

market commentary / global investment committee Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bonds 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. 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morgan stanley smith barney | aug. 8, 2011