January 16, 2013
GLOBAL CROSS-ASSET STRATEGY
MORGAN STANLEY RESEARCH
Global Cross-Asset Strategy
Investment Lessons from Financial Repression
Global Cross-Asset Strategy
Group
Morgan Stanley & Co. LLC
Gregory Peters +1 212 761-1488
Financial repression is already occurring because of the Fed. A key pillar of financial repression is
artificially depressed nominal rates, which appears to be the consequence of the Fed’s ZIRP and QE3
policies. The unsustainable amount of public sector liabilities means repression, in one form or another,
will continue indefinitely. Unsustainably high public sector leverage also means that a cost will be
imposed on the private sector, the question is when and how.
Jason Draho +1 212 761-7893
Brennan Leong +1 212 761-9729
Jerry Chen +1 212 761-8591
History suggests that repression doesn’t have to be bad for equity markets. In a recent study,
Carmen Reinhart and Belen Sbrancia argue that financial repression was prevalent in the US over the
1945-1980 period. This helped to “liquidate” the massive public debt built up during WWII. During the
entire period of repression, S&P 500 returns averaged almost 10% a year. Even when real rates were
negative, S&P returns averaged about 3%. However, returns were significantly negative in years with
inflation shocks.
Morgan Stanley Australia Ltd.+
Current conditions for debt and growth are much less favorable than post-WWII, a key reason
why returns are likely to be lower. In the current cycle, public sector debt has returned to WWII levels.
But private sector debt is much higher – comparable to levels preceding the Great Depression –
constraining the ability of consumers to drive growth. These high debt levels contribute to a current
growth outlook that is much worse than it was post-WWII. Equity returns under the current financial
repression regime will be hard pressed to match those of 1945-1980. This prospect is a major reason
why we would only gradually shift out of bonds and into equities in 2013, despite record low yields.
Due to the nature of the fixed income
market, the issuers or bonds of the
issuers recommended or discussed in
this report may not be continuously
followed. Accordingly, investors must
regard this report as providing standalone analysis and should not expect
continuing analysis or additional
reports relating to such issuers or
bonds of the issuers.
Gerard Minack +61 2 9770 1529
Katie Hill +61 2 9770 9290
Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have
a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in
making their investment decision.
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Executive Summary
•
What is “financial repression”? One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise prevail.
This lowers a government’s interest expense and contributes to deficit reduction; when inflation exceeds the rate paid on government debt, this
liquidates existing debts. The main features of financial repression can be described as: Explicit or indirect caps / ceilings on interest rates; creation
and maintenance of a captive, domestic investor base; and direct ownership of or extensive management over banks and other financial institutions.
•
The unsustainable amount of public sector liabilities makes financial repression inevitable. Both public and private sectors are highly levered.
In fact, a stylized government balance sheet of all assets and liabilities shows that most developed economies are effectively insolvent. This means
that the public sector will eventually impose a cost on the private sector in the form of higher taxes and reduced services – it’s a question of when
and how. To get out from under this debt burden, countries can either grow their way out, restructure or default on the debt, or inflate the debt
problem away. Growth is very unlikely to reach the necessary levels, while default is politically unattractive. Inflation is the remaining option. High
inflation is not necessary, provided there is a policy to suppress interest rates so real rates are negative, which liquidates the debt burden.
•
Repression is already occurring because of the Fed. A key pillar of financial repression is artificially depressed nominal rates. The Fed’s ZIRP
and QE3 policies are consistent with repression. However, there are few other policies in the US that explicitly cap deposit or savings rates, require
purchases of Treasuries, or restrict capital flows. Augmenting the effect of repression are fixed income market technicals. The limited fixed income
supply due to deleveraging and strong demand for bonds is also putting downward pressure on yields. Added to that, investor risk aversion and a
shrinking global supply of risk free securities is also pushing Treasury yields lower. Thus, very low rates could reflect, in part, “voluntarily” repression.
•
History suggests that repression doesn’t have to be bad for equity markets, though it depends on economic conditions. Financial
repression was prevalent in the US over during 1945-1980. The Fed kept nominal rates lower than would otherwise prevail, while other policies,
such as regulations on S&Ls and caps on deposit rates, also contributed to financial repression. The benefit is this helped to effectively “liquidate”
massive amount of public debt built up during WWII. Moderate and steady inflation contributed to this liquidation. During the entire period of
repression, S&P 500 returns averaged almost 10% a year. Even when real rates were negative, S&P returns averaged about 3%. However, returns
were significantly negative in years with inflation shocks. Treasury returns were positive on average, due entirely to carry offsetting rising rates.
•
History offers hope for future returns, but initial debt and growth conditions today are much less favorable than post-WWII. In the current
cycle, public sector debt has returned to WWII levels. The big difference is that private sector debt is much higher – more comparable to levels
preceding the Great Depression, when stock returns were very poor. Compounding this problem is that the current growth outlook is much worse
than it was post-WWII. This suggests that equity returns going forward will be hard pressed to match those of the 1945-1980 repression period.
•
Financial repression plays a role in our asset allocation outlook for 2013, which sees a gradual shift out of bonds into equities. Repression
is likely to keep rates low for a long time. Low rates make government bonds unattractive, but a big move higher in rates that could trigger a major
reallocation out of bonds into equities looks unlikely in 1H13. The combination of negative real rates and modest inflation can be supportive of
equities, but low growth and deleveraging headwinds mean that we are likely to be in a low return world.
2
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
What Is Financial Repression?
One of the main goals of financial repression is to keep nominal interest rates lower than would otherwise
prevail. This lowers a government’s interest expense and contributes to deficit reduction; when inflation
exceeds the rate paid on government debt, this liquidates existing debts.
The main features of financial repression can be described as:
• Explicit or indirect caps / ceilings on interest rates
– Government regulation, e.g., regulation Q in the US
– Ceilings on bank lending rates
– Central Bank interest rate targets
• Creation and maintenance of a captive, domestic investor base
– Capital account restrictions and exchange controls to force a ‘home bias’
– High reserve requirements
– Regulatory measures that require financial institutions to hold government debt in their
portfolios (pension funds have historically been a target)
– Transaction taxes on equities; prohibitions on gold transactions
• Direct ownership of, or extensive management over, banks and other financial institutions
– Restriction of entry into financial markets
– Directing credit towards certain industries
Source: The Liquidation of Government Debt, Carmen Reinhart and M. Belen Sbrancia; Federal Reserve, Morgan Stanley Research
3
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Why Financial Repression Is Inevitable
• Both the public sector and the private sector are highly levered. To get out from under this debt burden, countries can either growth their way out, restructure or
default on the debt, or inflate the debt problem away. Growth is very unlikely to reach the necessary levels, while default is politically unattractive. Inflation is the
remaining option. High inflation is not necessary, provided there is a policy to suppress interest rates so real rates are negative, which liquidates the debt burden.
The Global Debt Super Cycle
700
Debt Outstanding % GDP
600
500
400
300
200
100
0
US
Germany France
UK
Public Debt
Spain
Portugal
Italy
Greece
Japan
Total Less Public
Source: Various national sources, Haver Analytics, Morgan Stanley Research
Note: As of 2Q12, using annualized SA GDP
4
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Think of Sovereigns as a Corporate: A Stylized Government Balance Sheet
Ass ets
Lia bilities
Pe o p le ’s e qu it y
P ow e r to ta x (Ne t
p re se n t valu e o f fu tu r e
ta x re ve n ue s)
So c ia l lia b ility ( Ne t
pr e se n t va lu e o f fu tu re
pr im a r y e xp en d itu re )
R ea l a s s et s
(b u ild in g s, m ilita ry
e q u ip m e n t, e tc)
G ro s s D eb t
E q uity h o ld in gs (e .g .
sta ke s in b a n ks)
F is ca l a s s et s a n d
lia b ilit ie s
F ina n c ia l a s s e ts a n d
lia b ilit ie s
O t he r fina n c ia l a s s e ts
(lo an s, ca sh , e tc)
Source: Morgan Stanley Research. Please see Sovereign Subjects, August 25, 2010 by Arnaud Mares.
5
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Considering All Assets and Liabilities, Sovereigns Are Highly Indebted, If Not Insolvent
• Under the stylized government balance sheet, most developed country governments have negative net worth – the present value of their income streams (tax
revenues) is less than that of their liabilities (including future health and retirement liabilities). This means that the public sector will eventually impose a cost on the
private sector – it’s a question of when and how.
Illustrative Estimates of Government Net Worth
200%
0%
-200%
% OF GDP
-400%
-600%
-800%
-1000%
-1200%
Long-term Cost of Ageing
Initial Fiscal Position
-1400%
Initial Debt
-1600%
IT
DE
BE
FR
PT
USA
UK
ES
IR
GR
Source: EU Commission, Eurostat, CBO, IMF, Morgan Stanley Research
Note: Discount rate used in net worth calculations assume a rate that is 100bps above the nominal GDP growth rate across all countries; initial debt level is the
projected gross debt / GDP at end-2010; initial fiscal position is the 2011 cyclically adjusted primary deficit; long term cost of ageing is based on long-term
projections of age-related expenditures from the EU and IMF, pre-fiscal retrenchment. Please see Sovereign Subjects, August 25, 2010 by Arnaud Mares.
6
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Who Bears the Brunt of Government ‘Insolvency’?
Some or all of its stakeholders must suffer a loss
Who are the stakeholders?
•
Taxpayers – tax burdens increase
•
Public Services – lower government expenditure. Scaled-down government programs
•
Bondholders – relatively unscathed thus far…
• Outright default
• Repression – imposing on creditors a real rate of return that is negative or artificially low
• Currency devaluation via inflation
• Taxation and regulatory incentives on institutions to purchase government debt at uneconomic
prices
Source: Morgan Stanley Research
7
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
The US Example – It Is Likely That ALL Stakeholders Will Suffer a Loss
• The gap between revenue and spending in the US remains large. The latest fiscal cliff plan projects revenues at 19% of GDP. In contrast, current federal
expenditures are 24.3% of GDP, though interest costs are only 1.4%. However, because of rising entitlement costs, principally Medicare, these are forecast to rise
to 42.8% and 15.8%, respectively. Given this large gap between expenditures and revenues, ultimately both taxpayers and public services will suffer, it’s only a
question of how the losses are allocated.
Federal government revenues currently projected at
19% vs. the long-term average of 18.5%. If all tax
cuts had expired, revenues would have been 21.5%
% of GDP
Allow Bush-era
tax cuts to
expire
22
21
Federal government expenditures (% of GDP)
FY
2010
2030
2050
Medicare and Medicaid
5.5
9.2
13.0
Social Security
4.8
6.0
5.9
Other noninterest
outlays
12.5
8.7
8.1
Total Excluding
Interest
22.9
23.9
27.0
1.4
7.2
15.8
24.3
31.1
42.8
Latest Cliff Plan
20
Extend Bushera tax cuts
19
18
17
Interest
16
15
1955
Total
1967
1979
1991
2003
2015
2027
2039
Source: CBO Long Term Budget Outlook, June 2011 (using the ‘alternative fiscal scenario’)
Source: CBO Long Term Budget Outlook, June 2011 (using the ‘alternative fiscal scenario’)
8
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Are We Presently Repressed? Arguably Yes, but…
• A key pillar of financial repression is artificially depressed nominal rates. The Fed’s ZIRP and QE3 policies are consistent with repression. However, there are few
other policies in the US that explicitly cap deposit or savings rates, require purchases of Treasuries, or restrict capital flows. The exceptionally low yields are also a
product of a shrinking supply of risk-free assets globally, combined with heightened risk aversion amongst investors fuelling the demand for Treasuries. Thus, very
low rates could reflect, in part, “voluntarily” repression.
Yes, if negative real rates are the criteria...
10%
5y
UST Real Yield (%)
…but negative rates also reflect flight to a shrinking
supply of ‘risk’ free assets – ‘voluntary’ repression
10y
59%
AAA assets as a % of Global Fixed Income markets
8%
57%
6%
55%
4%
53%
2%
51%
0%
49%
-2%
-4%
1953
1961
1969
1977
1985
1993
2001
Source: Bloomberg, Federal Reserve, Shiller, Morgan Stanley Research
2009
47%
Jan-09
Jan-10
Jan-11
Jan-12
Source: BAML, Bloomberg, Morgan Stanley Research
9
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
The Fed Is the Main Source of Financial Repression
Due to QE3, the Fed balance sheet will grow
even larger, for an uncertain time
4.5
Little chance of a policy rate rise any time soon
Vote of FOMC members on the timing of first policy rate increase
14
($tn)
Number of Participants
13
12
4.0
MS Estimates
3.5
12
Other
Foreign Swap Lines
Loans to Domestic Banks
Bank Loans
Agency & GSE
Treasuries
3.0
2.5
September
10
December
8
2.0
6
1.5
4
3
1.0
3
2
2
2
0.5
1
1
0
0.0
2001
2003
2005
2007
2009
2011
2013
Note: 2013 are estimates based on Fed purchases of $40bn / month of Agencies H1, $45bn / month in
H2, $60bn / month of UST in H1, and $65bn / month in H2 (areas shaded)
Source: Federal Reserve Board, Haver Analytics, Morgan Stanley Research estimates
2013
2014
2015
2016
Note: In the above panel, the height of each bar denotes the number of FOMC participants who judge
that, under appropriate monetary policy and in the absence of further shocks to the economy, the first
increase in the target federal funds rate from its current range of 0 to ¼ percent will occur in the
specified calendar year.
Source: FOMC December 2012 Summary of Economic Projections
10
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Fixed Income Supply and Demand Technicals Augment the Effect of QE3 on Rates
• In addition to ZIRP, the combination of a limited supply of fixed income securities in the US due to deleveraging and strong demand for bonds is also putting
downward pressure on yields. Much of this demand is from the Fed. Taking into account expected QE3 purchases of Treasuries and Agencies, the net supply of
fixed income for private investors in 2013 could be negative. These market technicals are not a form of repression, but they amplify the effects of repression.
3.0
($tn)
Based on expected issuance in 2013 and plausible Fed purchases in
QE3, the net supply of fixed income could well be negative in 2013
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
Municipal
Treasury
Mortgage
Corporate
Agency
Money Market
-1.5
ABS
Net
-2.0
Net - LSAP
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Note: 2012 is 2Q SAAR. 2013 projected supply assumes $856bn in net Treasury issuance and similar net issuance in other categories similar to 2012 net supply. The Fed LSAP
purchases are assumed to be $540bn in Treasuries ($45bn per month) and $480bn in MBS ($40bn per month)
Source: Federal Reserve Board, Haver Analytics, Morgan Stanley Research estimates
11
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
An End of Fed Repression in Sight? Not with Fiscal Dominance of Monetary Policy
% of GDP
300
Federal Debt Held by the Public
Extended
alternative fiscal
scenario
250
•
December FOMC minutes raised speculation
about when the Fed will end QE3, raise rates
•
Fiscal cliff deal didn’t, and the upcoming debt
ceiling debate is unlikely to include much fiscal
consolidation
•
That’s not good for deficit reduction over the
next 10 years, while the long-term fiscal outlook
is an even bigger concern
•
Lack of fiscal progress leaves monetary policy
as the only game in town
•
Fed repression could persist with more
unconventional monetary policy; e.g.,
200
150
100
50
• Targeting nominal GDP growth, not inflation;
0
1940 1948 1956 1964 1972 1980 1988 1996 2004 2012 2020 2028 2036
• Inflation band around 2%, not 0-2%;
• Negative nominal rates
Source: CBO June 2012 Long-Term Budget Outlook, Morgan Stanley Research
12
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Lessons from History – When Has Financial Repression Occurred?
• In the US, financial repression was prevalent during the 1945-1980 period, as the Federal government sought to liquidate WWII debts. This could be achieved with
low or negative real rates, as that would reduce interest costs and shrink the debt obligation in real terms. The Fed achieved this via financial repression, which
kept nominal rates lower than would otherwise prevail, including a period from the late 1930s to early 1950s that kept composite Treasury yields below 2.5%.
• Debts could therefore be reduced by a mild but steady dose of inflation that lasted many years or by a sudden burst in inflation. In the post-war period, only two
inflation shocks resulted in negative rates; most episodes occurred in the 1970s due to Oil and Commodity price surges. S&P 500 returns were still positive when
rates were negative due to repression. But inflation shocks, though effective at reducing outstanding public debt, corresponded with very poor equity returns.
Index Level
160
140
120
100
80
60
40
20
0
1944 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980
Negative Rates, Normal Inflation
Positive Rates, Inflation Shock
Negative Rates, Inflation Shock
S&P 500
Source: Reinhart and Sbrancia (2011), Bloomberg, Morgan Stanley Research
Note: Real rates based on a weighted average coupon of a synthetic government debt portfolio; inflation shock defined as years where inflation during
that year was two standard deviations above its 10-year average; equity price index not total return index
13
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
A Small Sample, but Equities Did Okay, Provided No Inflation Shock, Same with Bonds
Annual equity returns under repression (19451980) were positive, except for inflation shocks
-25%
-20%
-15%
-10%
-5%
0%
5%
Treasury returns were modest, due entirely to carry,
which offset the effect of rising rates
10%
-10%
1945-1980
1945-1980
Negative Rates
Negative Rates
-'ve Rates, Normal
Inflation
-'ve Rates, Normal
Inflation
-'ve Rates, Inflation
Shock
-'ve Rates, Inflation
Shock
+'ve Rates,
Inflation Shock
Median S&P 500 price
return
Source: Reinhart and Sbrancia (2011), Bloomberg, Morgan Stanley Research
Note: Real rates based on a weighted average coupon of a synthetic government debt portfolio;
inflation shock defined as years where inflation during that year was two standard deviations above
its 10-year average; equity returns are price not total
+'ve Rates,
Inflation Shock
-5%
0%
5%
10%
Price return
Coupon
Source: Reinhart and Sbrancia (2011), Damodaran, Morgan Stanley Research
Note: Real rates based on a weighted average coupon of a synthetic government debt portfolio;
inflation shock defined as years where inflation during that year was two standard deviations above
its 10-year average; price and coupon return are derived from the median total return
14
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Similar Equity Returns in Other Countries that Experienced Repression
Nominal returns during financial repression were
positive, but uninspiring
However, liquidating debt came at a cost – real
returns were much lower, and negative in the UK
Median annual real returns
Median annual nominal returns
10%
15%
5%
10%
0%
5%
-5%
0%
-10%
-5%
-15%
-10%
-20%
-15%
-25%
Australia
Japan
UK
US
Australia
-20%
Japan
UK
US
-30%
-25%
-35%
1945-1980
Negative Rates
-'ve Rates,
Normal Inflation
-'ve Rates,
Inflation Shock
Source: Reinhart and Sbrancia (2011), Bloomberg, Morgan Stanley Research
Note: Real rates based on a weighted average coupon of a synthetic government debt portfolio;
inflation shock defined as years where inflation during that year was two standard deviations above
its 10-year average; equity returns are price not total
1945-1980
Negative Rates
-'ve Rates,
Normal Inflation
-'ve Rates,
Inflation Shock
Source: Reinhart and Sbrancia (2011), Damodaran, Morgan Stanley Research
Note: Real rates based on a weighted average coupon of a synthetic government debt portfolio;
inflation shock defined as years where inflation during that year was two standard deviations above
its 10-year average; equity returns are price not total
15
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Artificially Low Rates Benefited Some Sectors More than Others
Cyclical sectors outperformed during post-war boom
Index Level (Dec 1944 = 100)
1,000
Utilities outperformed when rates went negative
Average annual return
10.0%
Transport
Utilities
Industrials
900
8.0%
800
700
6.0%
600
4.0%
500
400
2.0%
300
0.0%
200
100
-2.0%
0
1944 1947 1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980
Negative Rates
Transport
Utilities
Industrials
Source: Reinhart and Sbrancia (2011), Dow Jones, Federal Reserve, Morgan Stanley Research
Note: Real rates based on a weighted average coupon of a synthetic government debt portfolio;
equity sector returns are price not total
-4.0%
1945-1980 Average
Negative Rates
Source: Reinhart and Sbrancia (2011), Dow Jones, Federal Reserve, Morgan Stanley Research
Note: Real rates based on a weighted average coupon of a synthetic government debt portfolio;
equity sector returns are price not total
16
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Public and Private Leverage Conditions Matter a Lot: Not Good in the Great Depression...
• During the Great Depression, the economy delevered as the private sector paid down substantial amounts of debt. Public sector debt increased initially, as much
due to negative GDP growth as increased nominal debt, but did not increase significantly until WWII. This contributed to poor stock returns over most of the period,
with sustained positive returns not occurring until 1942.
Private sector leverage was high at the start of the
Great Depression, deleveraging was necessary…
Debt / GDP
US Private Debt
250%
US Public Debt
…and that was a headwind for equity market
performance
Index Level
33
28
200%
23
150%
18
100%
13
50%
8
S&P 500
0%
1929 1931 1933 1935 1937 1939 1941 1943 1945 1947 1949
Source: Shiller, Federal Reserve, BEA, The Statistical History of the United States, From Colonial
Times to the Present, by Ben Wattenberg, Morgan Stanley Research
3
1929 1931 1933 1935 1937 1939 1941 1943 1945 1947 1949
Source: Bloomberg, Morgan Stanley Research
Note: Equity price index not total return index
17
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
…While They Were More Favorable During the Post-WWII Financial Repression Period
• Post-WWII, there was another significant deleveraging, except this time it was in the public sector, which built massive debt to fund the war. The key difference to
the Great Depression is that while governments were liquidating debt via inflation and repression, the private sector started with low debt levels and was able to
add leverage. This helped fuel growth, and contribute to the equity bull market that began in 1950, with annual equity returns in excess of 10%.
Financial repression liquidated government war debt,
while the private sector was able to add leverage
Debt / GDP
140%
Post-war consumer boom contributed to the
equity bull market
US Private Debt
Index level
US Public Debt
160
120%
140
120
100%
100
80%
80
60%
60
40%
40
20%
20
S&P 500
0%
1945 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978
Source: Shiller, Federal Reserve, BEA, The Statistical History of the United States, From Colonial
Times to the Present, by Ben Wattenberg, Morgan Stanley Research
0
1945 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978
Source: Bloomberg, Morgan Stanley Research
Note: Equity price index not total return index
18
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Current Leverage Conditions for the US Are Not Supportive, Nor Is the Growth Outlook
• In the current cycle, public sector debt has returned to WWII levels. The big difference is that private sector debt is much higher, more comparable to levels
preceding the Great Depression. Compounding the problem of these high debt levels is that the current growth outlook is much worse than it was post-WWII. This
combination of indebtedness and low growth suggest that the equity returns going forward will be hard pressed to match those of the 1945-1980 repression period.
The private sector is delevering, with little scope to add
leverage, while public sector debt is close to WWII highs
Government
Household
Debt / GDP
130%
Non-Financial
Financials*
Growth over the next five years more likely to resemble
the Great Depression than post-WWII
Average annual nominal GDP growth, %
8.0%
120%
7.0%
110%
6.0%
100%
5.0%
90%
4.0%
80%
3.0%
70%
2.0%
60%
1.0%
50%
40%
Jan-00
0.0%
Jan-02
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
Source: Shiller, Federal Reserve, BEA, The Statistical History of the United States, From Colonial
Times to the Present, by Ben Wattenberg, Morgan Stanley Research
Note: Financials include Agencies and GSEs
Great Depression
(1929-1949)
Post-War (1945-1980)
2009-present
Source: Historical Statistics of the United States, BEA, Morgan Stanley Research
19
MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Real Rates and Inflation Under Repression Could Be a Positive or Negative for Equities
• The effectiveness of financial repression, and it’s impact on returns, depends a lot on the level of real rates and inflation. Over the past 35 years, negative real
rates have corresponded with very low P/E multiples, indicating a distressed environment. But negative real rates because of repression need not lead to lower
valuations or low returns. Modest inflation has also been better for valuations, so low real rates because of repressed nominal rates is likely better for equities.
The P/E has tended to fall when real rates are negative
18
S&P P/E multiple has peaked with inflation in 1-2% range
P/E Ratio, x
20
18.0
18
17.0
16
16.6
15.4 15.2
16
14
Current
12
10
Median S&P 500 LTM P/E
14.5
14
12.93
12
10
10.8
9.6
8.4
9.0
8.1
8
6
8
4
6
2
0
4
< 0%
0 - 1%
1 - 2%
2 - 3%
3 - 4%
4 - 5%
5 - 6%
> 6%
<0% 0-1% 1-2% 2-3% 3-4% 4-5% 5-6% 6-7% 7-8% 8-9%
Real 10-Year Treasury Rate
9- >10%
10%
Level of Y/Y Headline CPI Inflation
Source: Datastream, Morgan Stanley Research
Note: Based on historical data from 1978 - 2011
Source: Haver Analytics, Thomson Financial, Morgan Stanley Research
Note: Based on historical data from April 1953 to November 2011
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Financial Repression Impacts Our 2013 Asset Allocation Views
• Compared to 2012, we are shifting equities from UW to neutral, on a path to
OW; we reduced our credit OW to neutral.
Asset Class Views (FY 2013)
–
+
EM Equities
• With fixed income yields at record lows due to financial repression, we prefer
equities over bonds
Europe Equities
EM Credit
• However, with yields likely to stay low for a long time because of repression, we
wouldn’t make a major move out of bonds, as significant losses are unlikely
Europe Credit
Oil
• Related, a major asset allocation shift out of bonds into equities is unlikely in
1H13, as macro uncertainties remain high
Commodities
Japan Equities
• Overall, returns across asset classes are likely to be lower in 2012 than 2013, in
part because of financial repression and low growth
• Consequently, for alpha, we look to assets outside the US
US Equities
US Credit
EM Rates
German Bunds
US Treasuries
FX
EM Currencies
USD
GBP
EUR
JPY
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Appendix
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Summary of Financial Repression and Inflationary Periods
Country
Argentina
Period of study
1944-1974
RRR Liquidation Years
1944-1952, 1954-1974
Australia
Belgium**
India
1945-1968, 1971, 1976
1945-1974
1949-1980
Ireland
Italy
Japan
South Africa
1965-1990
1945-1970
1945-1980, 1989-present
1945-1974
Sweden
1945-1965
United Kingdom
1945-1980
United States
1929-1949, 1945-1980
1946-1953, 1955-1956, 1971, 1976
1945-1948, 1951, 1963, 1969-1974
1949, 1951, 1957, 1959-1960, 1964-1968,
1970, 1972-1975, 1977, 1980
1965-1966, 1968-1977, 1979-1982
1945-1947 1950-1951, 1962-1964, 1970
1962-1963, 1965, 1970-1978, 1980
1945, 1947-1949, 1951-1952, 1955-1957,
1959-1961, 1963
1947-1948, 1951-1952, 1956-1958, 1960,
1962, 1965
1948-1953, 1955-1956, 1958, 1962, 1965,
1969, 1971-1977, 1979-1980
1945-1948, 1951, 1956-1957, 1974-1975
Inflation Surprise Years*
1945, 1946, 1949-1951, 1959,
1972, 1973
1951, 1966
1972-1974
1973, 1974
1970, 1972, 1973
1962, 1963
1973, 1974
1964, 1971-1974
1951
1970, 1971, 1973-1975
1946, 1966, 1968, 1969, 1970,
1973, 1974, 1979, 1980
*Defined as years when inflation is two standard deviations above its 10-year moving average
**Belgian debt data not available from 1964-1968
Source: The Liquidation of Government Debt, Carmen Reinhart and M. Belen Sbrancia; Federal Reserve, Morgan Stanley Research
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Disclosure Section
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
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Stock Rating Category
Overweight/Buy
Equal-weight/Hold
Not-Rated/Hold
Underweight/Sell
Total
Coverage Universe
Count
1103
1301
108
478
2,990
% of Total
37%
44%
4%
16%
Investment Banking Clients (IBC)
Count
% of Total IBC
% of Rating Category
436
497
27
111
1071
41%
46%
3%
10%
40%
38%
25%
23%
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Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Disclosure Section (Cont.)
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
Disclosure Section (Cont.)
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1-15-13 po
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MORGAN STANLEY RESEARCH
Investment Lessons from Financial Repression
January 2013
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