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Opportunities in Places That Others Ignore
June 01, 2007

By Takehiro Sato | Tokyo

Concerns about the stock business in Japan

Not surprisingly, our visit to investors in the US last week showed frighteningly little enthusiasm for Japan. A real-money fund manager who I have known for many years finds the situation in Japan boring and instead spoke passionately about China and even Philippine stocks. This view raises some concerns about the future of the stock business in Japan. Is the Japanese market that unappealing?

Investors have good reasons for keeping their distance from the Japanese market. Numerous factors are hurting interest, including the prospect of lower total demand with the aging and declining population, the sluggish pace of overcoming deflation, a government macro policy that places more emphasis on preventing an asset bubble than cultivating asset markets, and conservative profit guidances in corporate disclosure. We are certainly somewhat hesitant to aggressively recommend that investors buy Japanese stocks.

Opportunities in place that others ignore

To succeed, though, investors should find opportunities in places that others ignore. Chinese stocks are clearly experiencing a bubble similar to in Japan in the late 1980s, and the only question is when the bubble will burst. While it is difficult to beat the market by sticking to a bearish stance, the final return could be fairly low if investors hold positions through the Beijing Olympics. The Chinese market has been correcting again in late May following a hike in the stamp duty rate on securities trading aimed at reining in stock prices. Our Chinese economist, Qing Wang, anticipates some progress in controlling the market within this measure, in contrast to past attempts, since market valuation is much higher than when the government previously raised the stamp duty rate. Our Chinese equity strategist, Jerry Lou, thinks that authorities are determined to make a serious change and likely to introduce a chain of new measures if the market rebounds quickly again.

The Japanese market, meanwhile, faces little risk of a major sell-off, such as the dip from global risk reduction in May and June 2006, in the near term precisely because of recent weakness. Indeed, Japanese stock prices rallied substantially at the end of May as Chinese stocks adjusted. Further, Japan’s macro environment remains firm, albeit followed by an outstanding rebound in the previous quarter, with solid support from employment and consumption, as evidenced by GDP data for Jan-Mar 2007 and the April Labor Force Survey. Although personal consumption is unlikely to accelerate to 3-4% annualized or higher, driven by consumption activity for the time being, we do not anticipate a consumption recession caused by asset price deflation as happened in 1998 and 2001. Machinery orders and other capex data lack momentum. Yet the recent Nikkei capex survey reports that large companies plan to increase spending by more than 8% in F3/2008. This is a reasonable level, despite being lower than last fiscal year’s 12%+ range. The sharp rebound in capital goods shipment data (+8.7% MoM; excluding transportation equipment) in April’s Index of Industrial Production could remove recent uncertainty about capex. We think the impact of changes to the depreciation tax system had a role in the unexpected 0.9% QoQ decline in Jan-Mar GDP-based real capex as companies waited to acquire machinery equipment and other fixed assets since the new system applies to assets purchased from April. This implies a sharp rebound in Apr-Jun capex as compensation for the Jan-Mar decline. We think that investors might be underestimating the outlook for capex.

Meanwhile, the Japanese economy is likely to remain in a lukewarm Goldilocks state from a price perspective, with modest YoY price declines during 2007 as a backlash from last year’s higher crude oil prices and a sluggish pace of overcoming deflation. So, equity investors looking for robust change might be bored. However, the real aim of investing should be finding undervalued stocks that others ignore. We expect stronger interest in the Japanese market if Chinese stocks adjust, since it is trading much less expensively than the Chinese market (despite being more expensive than the US market) and has less downside risk. Rather, the previous pattern of Chinese market setbacks causing a decline in Japanese stock prices was unnatural.

Is the economy moving out of the lukewarm state?

There are also some signs of change to Japan’s lukewarm state. While economic indicators are fairly mixed, recent bank lending data show 0.5-0.6 ppt YoY upside, with a boost from previous large-scale M&A deals. This confirms some corporate demand for M&A-related capital, even with weak loan demand for capex and working capital. These companies are actively expanding leverage with debt and no longer operating under the asset-deflation mindset of downsizing balance sheets. While this approach might not please the credit market, we think it should be more actively welcomed by equity investors since it clarifies growth efforts.

We anticipate greater corporate interest in raising RoE and market cap by incurring debt if this type of activity picks up. While companies obviously need investment opportunities that justify the debt, there is no reason why only Japanese firms would lack attractive investments when the global economy is steadily expanding at a nearly 5% pace even amid a slowdown in the US. Further, debt costs are much cheaper than capital costs since the BoJ’s forward-looking strategy of continuous monetary tightening under disinflation conditions is promoting a flatter yield curve and companies could reasonably borrow from banks to fund share buybacks. We think that smart executives are reluctant to pursue this course, despite understanding the necessity, because of the disdain for debt among executives and even some shareholders cultivated during 15 years of asset deflation. Indeed, financial leverage is no longer declining, but has not established a clear bottom yet.

Investors have an increasingly important role in debunking entrenched views from asset deflation and getting companies to strengthen capital policies. We advised investors to aggressively encourage executives before complaining about the lagging Japanese market. The Japanese market offers opportunities from its underperformance if companies understand the importance of capital policies and act in accordance with helpful shareholder assertions.


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We Are ‘Global Re-Balancing Optimists’
June 01, 2007

By Stephen Jen and Luca Bindelli | London, London

Summary and conclusions

In this note, we argue that global re-balancing is indeed happening, with most of the growth in the world outside the US being from DD, rather than NX. 

While we are unsure if the US C/A deficit will decline substantially (i.e., below 4% of GDP) in the coming two years, we believe that, in the current cycle, the US C/A deficit (as a percentage of GDP) will continue to shrink, both due to the deceleration in US DD and, more importantly, DD growth in the rest of the world.  Even when the US economy recovers toward trend growth by end-2007 — a process that may have just begun — the US C/A deficit will be lower (as a percentage of GDP) than that in 2006.

Narrowing the US C/A deficit

We share our US economists’ view that the compression in the US C/A deficit we’ve witnessed since 3Q06 (from 6.9% of GDP in 3Q06 to 5.8% in 4Q06) is genuine, and that the US C/A deficit should shrink from 6.5% in 2006 to 5.7% and 5.1% in 2007 and 2008, respectively.  This prospective narrowing in the US external imbalance should temper, though not totally remove, some of the investors’ angst about the dollar. 

Domestic demand (DD) versus net exports (NX)

The key question we are trying to answer in this note is whether the compression in the US C/A deficit witnessed late last year will turn into a genuine trend.  Specifically, we will try to dispel the false notion that somehow most of the recovery in Europe is export-led, and the same goes for Asia

Further, Asia may be growing rapidly, but if most of the growth is NX, as in Germany, it is unclear how the US C/A deficit could continue to decline, unless US economic growth remains below trend.  In other words, we try to address the question of whether the compression in the US C/A deficit is temporary, and reflects demand compression in the US rather than growth in the rest of the world, if the latter represents NX rather than DD growth. (There are three broad perspectives in thinking about the US C/A deficit.  First, the ‘trade equation’ perspective, which assumes that the US C/A deficit is essentially the trade deficit, which, in turn, is a function of the exchange rate (the price effect) and relative income growth rates (the income effect) of the US and the rest of the world.  This is perhaps the most widely used perspective among investors and policy makers.  Second, the savings-investment (S-I) perspective considers the US C/A deficit as the balance between its S and I.  Third, there is the ‘capital flows’ perspective, whereby cross-border capital flows are the dominant drivers of the US C/A deficit, and the capital surplus, itself a result of the superior and hegemonic status of the US capital markets, necessitates a C/A deficit.)

All three perspectives should, in theory, be consistent with each other, though we have warned that the first perspective could be more misleading than the other two, as it is tempting to argue (as many have) that the US should use a weak dollar policy as its central policy plank to normalise its external imbalance.  Evidence, however, suggests that the price elasticities of trade for most developed countries have declined and are very low.  Therefore, the leverage from exchange rate changes on the US C/A deficit is limited.  Relative income growth, however, should play a more important role in helping the US compress its C/A deficit.  Convergence in the relative incomes could arise from a slowdown in the US investment rate and a rise in its savings rate (or a fall in its consumption), and/or an increase in investment and consumption for the rest of the world.

This is a critical question, since if the compression in the US C/A deficit were primarily because of the slowdown in the US, when the US economy recovers between now and the rest of this year, its C/A deficit could rise straight back to the 6.5-7.0% of GDP level. 

Euroland’s recovery has been driven by a recovery in DD

Facts contradict with popular perception on this issue.  Of the 3.0% GDP growth Germany enjoyed in 2006, only 1.2% came from NX.  For 2007, NX is expected to contribute 0.2% of the 2.6% of overall GDP growth.

While Germany’s NX have indeed been an important factor behind its growth, much of Germany’s trade is with other members of the EMU/EU.  If we net out intra-regional trade, we get a different picture for the growth composition of the EMU.  Eurostat reports that, for Euroland as a whole, NX contributed only 0.3 percentage points (pp) of overall growth in 2006, and is expected to account for only 0.1 pp in 2007 and -0.1 pp in 2008.  Therefore, virtually all of the acceleration in economic growth in Euroland has, and will likely continue to, come from DD — a point that our European economists have also made in the past.  In other words, Euroland’s recent economic recovery should, in theory, contribute to global rebalancing, just as the G7 Communiqués in recent years have predicted it would.

Doing the same exercise for Asia

Unfortunately, there is no agency equivalent to a ‘Eurostat’ that nets out trade for Asia; we have thus conducted the exercise of netting out the effect of intra-regional trade for Asia.  Our country set consists of China, Hong Kong, India, Korea, the Philippines, Singapore and Thailand As is the case with Euroland, most of AXJ’s growth is indeed coming from DD, not NX, contrary to popular perception. (If we look at China in isolation, without netting out its exports to the rest of Asia, we find that DD has accounted for some 24% of its growth in the past two years.)

Our thoughts
We have the following thoughts:

Thought 1.  Trade regionalisation is related to our findings.  We wrote a piece on this topic two weeks ago, arguing that trade has been more regionalised than globalised, especially in Asia but also in Europe.  The regionalisation of trade has provided a ‘Ballast Effect’, protecting the European and the Asian countries from bilateral exchange rate movements.  With trade regionalisation, national data give a misleading impression about the composition of DD and NX.  Only when trade data are ‘cleaned up’ — with intra-regional trade netted out — do we get a better picture of the roles that DD and NX play.  In general, we need to be more careful in interpreting trade data in a globalised/regionalised world, where a greater portion for the value-added chain is out-sourced to better capitalise on the relative comparative advantages of countries.  While the developed world out-sourcing to Asia is a familiar concept, some investors may under-estimate the extent of out-sourcing within regions.  In any case, with globalisation, while there is no doubt that trade is more important to growth than before, its role may be exaggerated if proper adjustments are not made to the data. 

Thought 2.  Fallacy of dis-aggregation.  At the global level, net exports cannot contribute to overall growth, since the world should run a trade balance with itself.  Thus, there is a fallacy of disaggregating macro data.  If the world is growing at 4.9%, unchanged from last year, then the world’s DD (the sum of consumption, investment, and government expenditures) must be growing at 4.9%.  Further, if the US DD has decelerated, then the DD of the rest of the world would need to accelerate for the world’s growth to remain unchanged.  While some individual countries may still be relying on NX for growth, aggregation should net out this effect.  What we have done in this note is precisely aggregate the data on a regional basis to net out this effect, and give what we believe to be a more relevant perspective on the question of global rebalancing.

Thought 3.  The notion of economic de-coupling is also related to our findings.  As we have argued in previous writings, regionalisation has helped the world to de-couple from the US.  Until recently, the popular view was in favour of global coupling; that with increased trade, international linkages should be tighter, forcing countries’ business cycles to be in sync.  The reality has been quite different, however.  The rest of the world has surprised many in successfully de-coupling from a slowing US.  The reason, we believe, is a combination of regionalisation and genuine DD growth.  We do not endorse the view that the world is simply ‘temporarily out of sync’ and that it is still tightly coupled. 

Impact on the dollar

We maintain a constructive structural view on the US dollar, and believe that the recent movements in the dollar are mostly a cyclical story.  The US, I believe, led the world out of its recession in 2002; its growth leadership was the root cause of its out-sized C/A deficit.  Now that the rest of the world has finally begun to recover, it is not surprising that the US C/A deficit should start to normalise.  Quietly, attracting little investor attention, an improvement in the US C/A deficit is taking place that will ultimately help stabilise the dollar. 

Bottom line

We believe that the narrowing in the US C/A deficit that we witnessed in late 2006 was the beginning of a genuine compression in the US external deficit.  Part of this C/A compression was due to the slowdown in US DD, but a significant part was due to an acceleration in the rest of the world’s DD.  Proper aggregation of trade, netting out intra-regional trade, reveals more clearly that most of Euroland’s and AXJ’s growth has been and will continue to be from DD, not NX.


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Raising Our GDP Forecasts
June 01, 2007

By Deyi Tan and Chetan Ahya & Tanvee Gupta | Singapore, Mumbai

1Q07 GDP numbers released

The Philippine economy grew 6.9% YoY in 1Q07 (versus +5.5% YoY in 4Q06), exceeding our and market expectations of 5.7% YoY.

What underpins strong 1Q07 performance?

The details of the components that underpinned the pace of acceleration were less exciting than the headline, in our view.  External balance was the biggest contributor to headline growth, adding 5.6 percentage points (versus +0.3%-pt in 4Q06).  Although exports grew 9.1% YoY (versus +2.3% YoY in 4Q06), the strong external balance also reflected the fact that imports contracted 2.5% YoY (versus expanding 1.4% YoY in 4Q06).  This was on the back of declines in electrical (-13.4% YoY) and fuel imports (-21.0% YoY).

In contrast, growth in domestic demand (including inventories) remained stable at 5.4% YoY (versus +5.4% YoY in 4Q06).  Underlying trends were slightly mixed, with only government spending showing a marked pick-up at 13.1% YoY (versus +9.9% YoY in 4Q06), which contributed +0.9%-pt to the headline number (versus +0.5%-pt in 4Q06).  This likely reflected a certain degree of pump-priming ahead of the May elections.  Private consumer spending growth was healthy at 5.9% YoY (versus +5.8% YoY in 4Q06). The investment trend picked up marginally at 2.7% YoY (versus +2.2% YoY in 4Q06).  This was underpinned by a 7.3% YoY rise in construction (versus +5.7% YoY in 4Q06).  Durable equipment, however, declined 0.4% YoY (versus -0.5% YoY in 4Q06).  Inventory was added at a slower pace, shaving 0.4%-pt off the headline number.  Total capex rose 0.6% YoY (versus +1.8% YoY in 4Q06). 

What to expect going forward?

We see several factors that should help support economic growth.

1) Liquidity tide and low rates to support credit cycle: As with other countries in the region, the increased global appetite for emerging market assets and the continued rise in balance of payments surpluses are resulting in large foreign inflows.  The system is consequently flush with liquidity.  The latest data show the outstanding stock of reverse repurchase agreements standing at US$6.8 billion as of mid-April, up US$1.8 billion from the US$5.0 billion seen in early January.  This compares with a US$0.3 billion increment in the preceding period.  Indeed, the excess liquidity helped yields on the 91-D Treasury bill stay low at 2.9% in April after falling by 358 basis points from their peak of 6.5% in June 2006.

The central bank has kept the reverse repurchase rate at 7.5% while keeping the tiering system that pays a lower rate for placements exceeding a stated amount.  We do not expect the central bank to lower rates further, as the rate on placements in excess of PHP 10 billion is already low at 3.5%.  However, while this is the case, we believe that lending rates still have some way to go, since their decline has lagged the decline in government securities yields so far.  We believe that this would lend further support to the credit cycle that is already under way.  As it is, the latest data show commercial loan growth accelerating from 6.1% in 3Q06 to 9.0% YoY in 1Q07.

2) Overseas workers’ remittances: Overseas workers’ remittances amount to 11% of GDP and are a crucial support for the economy.  The majority of remittances come from the US (60%), Saudi Arabia (9%) and Japan (3.3%).  Growth in workers’ remittances has decelerated slightly, from 33.9% YoY (3MMA) in December 2006 to 23.9% YoY (3MMA) in March 2007.  However, with recent data pointing to a likely bottoming in the US economy in 1Q07 and an expected capex-led recovery in Japan, we look for a re-acceleration in remittances to continue to fuel consumer spending in the economy.

3) External demand improvement in 2H07: The US ISM New Orders Index, which we use as a leading indicator for export demand, has recovered in the past three months or so.  Although the indicator typically leads by about 4-6 months, the Philippines’ export performance has shown an early-cycle acceleration.  Indeed, we expect this to continue with the recovery in the US export market.  

In view of the better-than-expected 1Q07 results, the impact from the credit growth cycle, and the external growth environment, we are raising our 2007 GDP growth forecast from 5.4% to 5.8% and our 2008 forecast from 5.2% to 5.8% as well.


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United States
Corporate Profits, the Dollar and Global Growth
June 01, 2007

By Richard Berner | New York

US corporate profits are decelerating and profit margins are flattening, courtesy of slower US growth and fading operating leverage.  That’s not exactly news to investors.  While first-quarter S&P earnings results handily beat expectations, with operating earnings rising 8.2% from a year ago, the results confirmed that the record-breaking era of double-digit earnings growth that began in 2002 is over.  Likewise, the just-released “economic” after-tax corporate profits consistent with the national income and product accounts (NIPAs) rose by 6.4% over the same period.  And the result is hardly a surprise; analysts like me have been expecting the slowdown for more than a year, and I expect the slower earnings pace to continue (see for example, “Corporate Profits: Deceleration Ahead,” Global Economic Forum, March 31, 2006).

However, to assess the earnings outlook, it’s important to recognize the emerging sharp dichotomy between the domestic and global sources of US earnings.  Domestic earnings growth has slowed sharply, to just 3.4% using NIPA metrics, and domestic factors such as fading operating leverage are still likely to dominate the earnings picture.  But two global factors are also at work: The dollar’s recent decline, coupled with continued hearty global growth, is sustaining high US profit margins and partly offsetting emerging challenges to Corporate America’s bottom line.  Using the NIPA yardstick, earnings from overseas rose by 15.6% in the first quarter.

These global factors now matter relatively more than in the past, partly because economies abroad represent a bigger slice of the global economy and they are growing faster than ours.  Especially because Corporate America’s results from abroad also benefit from operating leverage, the upside may continue to be a pleasant surprise.  The risk, however, is that investors forget that leverage can work both ways: Just as a cyclical global upswing has boosted earnings over the past year, slower overseas growth if it materializes likely would restrain any domestic rebound in the bottom line in 2008.  Here’s why.

Home-grown factors still dominate the US corporate earnings picture, and a look at the analytics of profit margins helps sort them out.  As every investor knows, margins have exploded since their trough late in 2001.  Measured as the quotient of “economic” profits to corporate GDP, margins rose by 560 basis points to a record of 14.6% by Q3 2006. 

Four domestic factors fueled the rise: First, companies were able to exploit the high levels of operating leverage in their business.  High fixed costs — primarily for depreciation — have given Corporate America significant operating leverage.  When spread over a broader base in recovery and expansion, such costs decline significantly and contribute to a surge in margins.  Over the past five years, depreciation charges as a share of GDP have declined by 230 basis points.  In addition, CFOs have been extraordinarily disciplined about capital spending and capital allocation over the past five years as they purged the lingering excesses of the bubble years and markets rewarded them for boosting returns on invested capital.  That capital discipline and the resulting steep climb in operating rates — 860 basis points in manufacturing — helped companies restore lost pricing power, boosting both the top and bottom lines.  Third, corporate interest expense has declined as a share of corporate GDP by 220 basis points in the past six years, the product of both declining interest rates and CFOs’ efforts to clean up their balance sheets.  Finally, strong productivity gains kept unit labor costs subdued.  Over the five years ending in 2006, productivity in nonfarm business rose by an annual average of 2.4%, restraining the rise in unit labor costs to an annual rate of 1.6%.  That helped bring compensation charges down as a share of GDP

As I see it, three of those four factors have faded, flattening margins.  Operating leverage has dwindled as companies begin to shift into the long-awaited — albeit moderate — expansion phase of the capital spending revival.  The combination of higher financial leverage and rising interest rates will soon boost interest expense.  And over the past year, as employment has caught up with the economy and compensation accelerated, unit costs accelerated as well.

But globalization means that global factors now matter relatively more than in the past.  Indeed, according to our US equity strategy team, the top 25 companies in the S&P 500 derive more than half of their sales from overseas operations, and S&P 500 companies as a whole obtain 27% or more of their sales from abroad.  Thus, a weaker dollar and stronger growth abroad could be powerful offsets to fading domestic support for margins. 

A weaker dollar, if sustained, could support earnings through three channels.  First, it is already translating US companies’ overseas results in euros or yen into more dollars.  On a trade-weighted basis, the dollar has declined by 3.4% from a year ago, and our empirical work suggests that a 10% decline would boost US earnings from abroad by at least 3% and as much as 6%, boosting overall earnings by 150 bp.  So the 3.4% decline in the dollar may have boosted overall earnings by 50 bp.  But the effect could be larger, because the fixed weights in the trade-weighted dollar may mask regional shifts in the currency’s impact.  Notably, half of US foreign affiliate income originates in Europe, and the dollar has declined by 10.4% against the euro over the past year.  It’s reasonable to expect those effects to continue over the remainder of 2007.

A weaker dollar is also helping the top and bottom lines by combining with domestic factors to promote stronger pricing power for US companies (see for example, “The Dollar and Inflation,” Global Economic Forum, May 5, 2006).  The effect of a weaker dollar has begun to show up in US import prices; excluding fuels, such prices rose by 2.7% in the year ended in April.  The effect on domestic prices is less visible. But because there is comparatively little slack in the economy, I’m confident that, while it likely will be modest, it is on the way.  Finally, a weaker dollar at the margin will help US companies recapture market share.  The recent deceleration in real US exports, which rose by 5.2% in the year ending in March, is not encouraging in that regard, but I think that improvement in market share will come soon.

Of course, stronger global growth is also a factor lifting both US exports and US earnings; in fact, in my judgment, global growth is more important for both than the slide in the dollar.  Empirical work has long supported the idea that improving growth is several times more powerful for exports than a similar-sized percentage-point change in relative prices.  And earnings are increasingly leveraged to global growth as US direct investment spreads abroad.  Our work suggests that the leverage factor could be 5 to 1 or more; that is, a percentage point improvement in global growth would yield an extra 5 percentage points of US earnings growth. 

The outcome of this tug of war between domestic factors restraining earnings and global factors boosting them is obviously critical for financial markets.  Yet many investors aren’t worried about the earnings slowdown.  They believe that a slower US economy will ultimately bring about declines in longer-term yields, which would permit earnings multiples to expand.  But they seem to forget that the same global factors that are a cushion for earnings are also driving up global, and to a lesser extent, US yields (see “The Conundrum Unwinds,” Investment Perspectives, May 24, 2007).  For US equity markets, the global boom is thus a mixed blessing.  To be sure, equity-market valuations aren’t stretched, but my colleague Henry McVey’s COV analysis underscores that stocks aren’t as cheap as they were in February.  And what about the risks to growth? It’s certainly possible that non-US growth could remain healthy even if the pace of US economic activity slowed significantly.  But what are the risks to earnings if it does not?  That would expose the downside of operating leverage: Simultaneously slower growth in both the US and overseas economies would promote a significant deceleration in US earnings.

Some of the risks associated with this scenario have to do with the character of these global factors.  The combination of a rebound in US growth and still-strong global business conditions implies clear-cut upside risks to earnings growth.  In that context, however, there are also upside risks to both inflation and interest rates, both of which could pressure risky assets.  A benign decline in the dollar will likely be a boost to earnings and a plus for US equities.  But a decline in the currency associated with escalating inflation expectations, a loss of confidence in US policies, or protectionism would make US assets less attractive to global investors.  And of course, threats to growth, such as supply-induced energy shocks, would promote concern over future earnings gains.


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Sovereign Wealth Funds and Bond and Equity Prices
June 01, 2007

By David Miles and Stephen Jen | London, London

Asset prices should depend on the willingness of investors to take risks.  That willingness — or degree of risk tolerance — obviously differs across investors. What matters for asset prices is that the weighted average degree of risk tolerance and the weights should reflect the amount that different investors have to invest.

Sovereign wealth funds (SWFs) already have substantial assets. The way in which they invest reflects an attitude to risk of those who make the investment decision that is very different from the attitude to risk of those who invest most existing stocks of financial wealth owned by governments. Most of that wealth today is in the form of foreign exchange reserves, and overwhelmingly that is invested in relatively low risk and return assets (government bonds).

The likely growth of SWFs — and the substantially higher risk tolerance of those who will be taking their asset allocation decisions — is likely to be rapid enough that it will have a material impact on the average degree of risk tolerance of investors across the globe. That should have an effect on asset prices.

What we do here is report some calculations to estimate what the scale of the effect might be. To do this, we use a very simple model of the global capital markets. We focus on just two very broad classes of assets: equities (or risky assets) and bonds (relatively safe assets).

We use an asset pricing model that captures the essentials that are at work in financial markets and that determine the relative returns (and therefore price) on more and less risky assets. First, we make some educated guesses as to how significant SWFs will become; then we turn to the implications of that for bond yields, for the return on equities and for the equity risk premium.

The importance of SWFs now and into the future

In recent reports, we have estimated that SWFs globally, in the near future, should hold about US$2.5 trillion. In comparison, the world’s official foreign exchange reserves are now of the order of US$5.1 trillion — roughly double the size of the SWFs.  To simulate a possible scenario for the future trajectories of the SWFs and the official reserves, we make the assumption that most central banks have enough foreign reserves for liquidity purposes and that additions to foreign exchange holdings generated by future current account surpluses (from both oil and non-oil trade) accrue to the SWFs rather than add to the stock of official reserves.  We assume that the compounded investment returns on existing assets stay with the respective funds — be they official reserves or SWFs; we assume that SWFs enjoy a higher return. 

Total global financial assets are roughly around US$100 trillion. We assume that this stock grows by the likely average return on a portfolio of assets roughly half invested in stocks and half in bonds. We take that return to be about 7.5% in nominal terms — a figure consistent with the asset pricing we use.

SWFs could potentially grow to US$17.5 trillion in the next 10 years, compared to a figure of around US$10 trillion for official reserves.  During this time, total global financial assets could roughly double.  By about 2020, the share of SWFs in global wealth is almost four times higher — growing from around 2.5% of global financial assets to over 9%.

Forex reserves fall slightly as a proportion of total global financial assets — a reflection of our simplifying assumption that investment returns drive both the growth of aggregate financial assets and the stock of forex reserves, and that forex returns earn a somewhat lower return than on global portfolios. In contrast, SWF assets grow much faster — a reflection of the assumption that those countries with the largest current account surpluses continue to run them and channel the new surpluses largely into SWFs.

Clearly, there is great uncertainty about the evolution of SWFs and forex reserves relative to total global assets. Our assumption, for the purposes of the projections, is that forex reserves have risen to a level such that they stop growing faster than global financial assets. Current account surplus countries now channel new investments overwhelmingly into SWFs. In the rest of this report, we consider what the implications for asset prices would be if that turned out to be the case.

The link between risk aversion, asset prices and portfolio allocation

We simplify enormously by assuming that there are safe assets (‘bonds’) and risky ones (‘equities’). Conventional wisdom today is that the equity risk premium — the average excess return on equities over bonds — is around 3.5-4%. The annual standard deviation of the return on equities, over the last few decades and in the world’s major stock markets, has been around 20% a year; recently it has been lower. We set it at 17.5%.

Step 1: The implied risk aversion of SWFs and reserve managers

Many asset pricing models, when we assume that expected returns and volatility do not change over time, yield a simple formula for the optimal portfolio shares held by an investor in risky over safe assets. The asset share in risky assets (α) is:

α = expected excess return/(risk aversion parameter * volatility)

Given this, and in the light of the typical portfolios held by managers of foreign exchange reserves and SWFs, we conclude that risk aversion of the former is dramatically higher than that of the latter. In our longer report (“Sovereign Wealth Funds and Bond and Equity Prices “, David Miles and Stephen Jen, May 31st) we describe exactly how we estimate the degree of risk aversion of different investors and how we use a particular asset pricing model to then figure out how asset prices might evolve. What we do is use that model to figure out how bond yields on safe (default-free) debt and on equity might change as the growing importance of SWFs gradually reduces the weighted average coefficient of risk aversion of global investors.

Here we will summarise the results.

The model implies that as SWFs grow substantially in importance, the overall global degree of risk tolerance in financial markets rises (or risk aversion falls). This reduces somewhat the attractiveness of relatively safe assets — ‘bonds’ — and increases the attractiveness of riskier, higher-yielding assets — ‘equities’. As a result of this shifting pattern of demand, we estimate that bond yields gradually rise over the next ten years by about 30bps. The required return on equity falls by about 50bps. The equity risk premium falls by 80bps. The average P/E ratio rises by about 4%.

An alternative scenario 
Not all investors are active all the time.  In our baseline scenario, we assumed that all the investors involved holding the approximately US$100 trillion worth of global financial assets are active and that all these assets are ‘in circulation’. In reality, there are funds that are held but not traded, and are, effectively, out of circulation.  If we assume that 30% of the world’s stock of financial assets (bonds and equities) is, effectively, out of circulation, then the impact on asset prices of the rising importance of actively traded SWFs is greater than in the base case. The rise in the ‘safe’ bond yield as a result of growing SWFs increases from 30bps in the baseline scenario to 40bps; and the fall in the equity risk premium is greater, rising from 70bps in the baseline scenario to 110bps.

Bottom line

We believe that the rising importance of SWFs will remain an important theme for the coming years.  Whether national governments and central banks are able to remain committed to riskier portfolios remains to be seen, as their resolve will be tested by periodic draw-downs.  However, based on our back-of-a-large-envelope calculations, we estimate that the emergence of SWFs could, ceteris paribus, push up ‘safe’ bond yields over the next ten years by 30-40bps and reduce the equity risk premium by 80-110bps. These are not small effects.


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Property Boom: This Time, It’s Different
June 01, 2007

By Deyi Tan and Chetan Ahya & Tanvee Gupta | Singapore, Mumbai

Property boom: 1996 versus 2007

The residential property market in Singapore has been on an upswing for some time now. Property prices have recovered to 2000 levels and are expected to rise further in the near term. The current property upturn brings to mind the 10-year run in the property market that peaked in 2Q96. However, we believe that this current upturn is different in the following aspects:

First, the breadth of the current property market upturn is significantly lower than the 1990s cycle.  The upturn so far has been largely restricted to the private property market, and this segment’s recovery has also been uneven.  There have been significant price gains in prime districts (+33% since late 2004) but the mid-tier and mass-market private property segments (in the non-core central district and outside the central districts) have lagged behind at 8-10% over the same period.  On the other hand, public housing prices – Housing Development Board (HDB) flats – have been stagnant at a 0.8% gain over the same period.  In the 1990s boom, there was a strong synchronous upturn in both private and public housing.

Second, the magnitude of price gains is also different.  The price recovery so far has been more gradual.  The private property market witnessed an average rise of 18.4% per annum from trough to peak between 1986 and 1996.  In the current cycle, private property prices have only risen by an average of 6.7% per annum since the trough in 2004.

Third, credit-funded purchases in the mass market segment played a key role in the 1990s property boom.  Mortgage loans were growing at double-digits and increasing to 43.1% (including HDB loans but excluding POSB loans) of GDP by March 1997 from 23.6% in March 1991.  However, in the current upturn, mortgage-lending growth has remained feeble, with the latest April data standing at 4.8% YoY.  Indeed, mortgage loans to GDP have declined by 10.2% to 58.6% (including HDB and POSB loans) as of March 2006 compared with 68.8% in March 2004.

In our view, these peculiarities stem from the fundamental difference in the nature of the two property upturns.  The 1990s boom had its start in mass-market demand.  Strong economic expansion simultaneously boosted income and immigration growth, which in turn fuelled first-home and upgrading demand.  In addition, favourable policy changes, such as more generous financing schemes and housing grants, also helped perpetuate the trend.  We believe that this explains why the property market was able to sustain the run from 1986 to 1996 before speculative demand that later took shape led the government to take draconian measures.

Basic facts

  • Home ownership level in Singapore stands at a high 93%.
  • 83% of the population live in public housing (HDB flats).
  • In terms of housing stock, 79% are HDB flats. 21% are private housing, of which 9% are condominiums, 6% apartments, 3% terrace houses and 3% detached or semi-detached.
  • Foreign ownership is relatively unrestricted, with prior approval required only for selected property types.

On the other hand, the current uptick has been supported by demand at the two extreme ends of the demand spectrum – investment demand at the top end of the market and first-home demand from the influx of immigrants.  Both are by-products of the extended liquidity cycle and above-trend global economic growth we have seen the last few years.  However, the current property boom lacks a third support, in our view.  Upgrading demand is relatively weak in this leg of the upturn.  

A two-tiered property market cycle 

Indeed, the investment nature of property demand helps explain the disparity in price rise between the different property segments.  It also explains why mortgage loan growth has been weak and the level of foreign interest high.  However, it is the strong macro-trend of widening income and wealth inequalities in Singapore that lies at heart of the disparity in property performance, in our view.

Strong economic expansion has led to healthy income gains for higher-income deciles.  This supports a pick-up in the higher-tier private property market.  This segment of the property market also gets further support from foreigners making investments. 

However, there has been little participation by lower and middle-income segment households in the current cycle.  Income growth in these segments has been generally weak in this cycle of economic expansion.  For example, families at the lowest deciles saw their incomes contract until 2005, despite consecutive years of strong economic growth, and only saw a reversal in 2006 when the lowest income decile saw its income per household member rise 6.6% YoY.  However, this has been primarily on account of more household members gaining jobs rather than an acceleration in wage growth.  Wage recovery for most income deciles has been relatively belated in this business cycle.  The absence of adequate income growth support will likely be the weakest link in the demand function for the mass market segment, in our view.

Where do we go from here?

At the trough in 2004, private property prices had declined by about 60% from the peak of the 1996 boom. The recovery in this cycle has resulted in about a 20% rise since then. Going forward, we expect the property price upturn to sustain over the next 18-24 months.  Property reflation should continue, as demand is healthy and supply is relatively tight.  However, the property market will likely remain two-tiered (in terms of private housing versus public housing and also high-end private housing versus mass market private housing) for the next 12 months at least, for the reasons we have mentioned previously.

Nonetheless, we see the possibility of price trends in the mass-market segment (both public and private) catching up thereafter.  If the global economy remains in a sweet spot with above-trend growth, we believe that this will ensure a healthy growth environment in Singapore, enabling acceleration in income growth for the lower/middle-income deciles.  This, in turn, could support in a rise in mass-market property prices.  However, the upside could be moderate, particularly for public housing, as the government will likely remain vigilant for any signs of overheating in this segment.  It wants to keep public housing affordable, such that 90% of Singaporean households can afford at least a 3-room flat and 70% at least a 4-room flat. 

Below, we analyse the property cycle outlook further by examining the trend in five key factors. On the demand side, we examine factors that affect demand for first homes, investment/second homes and from ‘upgraders’. On the supply-side, we look at existing excess supply (if any) and the potential supply coming on-stream. 

Demand side

Factor #1: Demographic trends

Impact on property cycle: Positive but hinges on business cycles

Demographic trends would give us an indication of incremental first-home demand. Population growth has been one of the factors most often quoted as a key driver of a structural property upturn.  Indeed, in the recent mid-term review of the Concept Plan (which looks forward to the next 40-50 years in terms of planning for land use and transport), the government has revised upwards its population parameter from 5.5 million (which was set in 2001) to 6.5 million.  With fertility rates having fallen below the replacement rate of 2.1, continued liberalization of immigration policies will likely be the key driver for this.  We are unconvinced by this structural angle to the property reflation story.  We believe that the 6.5 million population parameter can only be a long-term target.  Appropriate policy planning necessitates relatively glacial changes on this front and, in the long run, property supply is perfectly elastic.

We believe that, in the short-to-medium term, demographic trends will be influenced by economic cycles.  The economy needs to rely on the more elastic immigrant workforce to cope with market demand.  Indeed, the non-resident population has risen by an average of 42,500 persons per year (0.9% of the total population) in the past three years.  Based on our GDP growth estimates, property demand from immigrants would stay at reasonable levels, though it could decelerate slightly going forward.  If we add this to the resident population, which has grown at a CAGR of 1.7% YoY in the past five years (which means another 61,000 persons per year), this leads us to a total incremental demand of about 28,800 households (assuming a household size of 3.6) per year, which are looking to rent or buy property.  This compares with an average of 19,400 households in 2001-2006.

However, whether this level of incremental demand brings price pressures has to be seen from the perspective of the supply-side.  On that front, incremental supply coming on-stream seems to fall short.  This would hint at further price pressures.  We discuss this further below in the supply section.   

Factor #2: Affordability

Impact on property cycle: Mixed

We have assessed the trend in affordability using two different approaches.  A simple static way to measure affordability is to calculate the median price of property per unit area to median income ratio or total house purchase price to median income ratio.  A more dynamic way is to assess the affordability trend by estimating the viability of upgrading from a 110m2 5-room HDB flat to a 120m2 private condominium.  We have estimated affordability trends by taking the ratio of mortgage repayments to work income.  For the purpose of arriving at the mortgage loan quantum, we have reduced the housing equity on the existing home and other personal savings and pension fund balances from the cost of the condominium.  We also assumed that the borrower undertakes adjustable rate 20-year mortgage loans.

Key observations and thoughts from our analysis are:

Affordability has improved across the different housing types compared to the mid-1990s, and could trigger first-home buying: Affordability has improved for both public and private housing when compared to the peak of the property boom in the mid-1990s.  In fact, affordability of HDB new flats as well as private property is near the levels seen in 1990 when the previous property boom was in its infancy.  Indeed, we believe that this round of affordability improvement, anticipation of further improvement in home prices as well as the growing proportion of working age population will help demand for first-homes.

Affordability has improved across the different income segments compared to the mid-1990s: The trend of mortgage repayments as a percentage of income has improved.  Households in the top income decile took 37.2% of their work income to repay mortgages in 1996. However, they now only require 17.6% to do so.

Price of the new property to be purchased is the key factor influencing affordability levels: Although several factors such as housing equity at point of sales, savings (including pension fund balances) and interest rate movements influence the affordability trend, the price of the property to be purchased is the predominant driver of the current round of affordability improvement.  We believe that income-driven demand is more sustainable.

Affordability has improved for potential upgraders, but it is not enough:  When property prices collapsed between 2000 and 2004, affordability (in terms of mortgage payments as a percentage of work income) for the households in the 81st-90th income decile improved from 45.8% in 2000 to 32.1% in 2004.  The improvement in affordability was due to the fact that this income decile also saw healthy income growth at a relatively early stage of the economic expansion cycle. We believe that this triggered a wave of upgrading to private property.  As a result, the percentage of households dwelling in private property increased from 11.1% in 2000 to 14.8% in 2005.

Now, with about 15% of households, i.e., the top two income deciles, already staying in private residential property, demand to upgrade to private property will come from households in the 71st-80th income decile. For that income group, improvement in affordability has reduced the mortgage repayment to income ratio from 78.8% in 1996 to 57.3% in 2000, 41.0% in 2005 and 42.5% in 2006.  However, at this level, the financial burden to upgrade still seems high.  (As a benchmark, in calculating the maximum eligible loans, HDB assumes a monthly loan instalment at 40% of gross monthly income).  Upgrading demand from existing HDB dwellers would help to drive mass market private property.  However, our calculations show that demand from this front is most likely to be weak.

Factor #3: Investment homes

Impact on property cycle: Very positive; risks are high

On a simplistic analysis of rental yields, it is difficult to make a case for investment in luxury properties in Singapore.  Rental yields in Singapore are the lowest in Asia Ex-Japan.  Rental yields in countries with lower risk premiums are bound to be lower.  However, even if we compare rental yields less the one year G-sec rate, Singapore is still one of the least attractive.

Even though the case for luxury property investment on rental yields remains weak, the extended global liquidity cycle has led foreigners to continue investing in Singapore.  Investment demand has picked up post the government’s announcement to set up integrated resorts.  In addition, the easing of property market rules in 2005 at a time when the property market was relatively weak has also helped support demand.  The supply of luxury property developments that has come up since then has been easily absorbed.  Accounting for 24.2% of incremental demand in 2006, foreign demand has nicely pushed the uptick along.  Foreign money has flowed into luxury properties on expectations of capital appreciation gains, which has in turn fuelled further appreciation gains.

To the extent that the driver of price rises is partly trailing performance, the risks are also high in this segment.  However, barring any reversal in global risk appetite and/or a contraction in liquidity, we believe that the property price trend in this segment will remain strong in the near term.

Supply side

Factor #1: Vacancy rates

Impact on property cycle: Near-term positive

Excess supply appears minimal and further signs of tightness are emerging.  Indeed, 1Q07 vacancy rates in the private residential space have fallen to a low of 5.1%.  This coincides with the sustained cyclicalexpansion in the economy, which has to be met by an immigrant labour stream.  Even on the public housing side, the build-to-order scheme in which tenders for construction are called only when most apartments have been booked probably alleviated the excess supply situation in the late 1990s.  Industry sources put the excess HDB stock at 10,000 units.  This is just 1% of total stock.  Going forward, more tightness seems inevitable.  Vacancy rates could fall further when the several properties are pulled for redevelopment.  In fact, 1Q07 residential stock data indicate that this might already be coming through.

Factor #2: Potential supply stream

Impact on property cycle: Near-term positive; medium-term mixed

There is also limited supply coming on-stream for the next two years.  In the private property market, developers were initially cautious but have initiated projects with a lag following the continued acceleration in prices.  The bulk of the construction will likely take place in these two years.  Supply bottlenecks before an additional 7% of stock is completed in 2009 will increase prices pressures.  Our rough benchmark of an annual incremental demand from 28,800 (12% of existing available stock) households suggests that there could still be some tightness in 2009, despite the supply of 16,797 private units coming on-stream.  However, with the demand-supply mismatch closing significantly in 2009, we believe that price acceleration could ease.

To be specific, we are less worried about the effect on prices from the supply of prime property coming on-stream in 2009.  Property investors/speculators typically buy into a ‘virtual supply’, i.e., uncompleted units, and flip the property for a profit before they are completed.  Hence, we believe that whether/when the property is physically completed matters less for the price cycle of this property segment.  On the contrary, the physical completion of the mid-tier and mass market property segments will matter for its price cycle.  This is especially so since they are purchased for occupation purposes.  Hence, this could increase the bifurcation in the property market at a time when demand from upgrading and income growth is increasing and working in the reverse direction.

Macro implications

The differences in the nature of the property booms have different implications for the macroeconomy.  To be sure, the construction impact is intact.  However, inflation and wealth effects are likely to be relatively subdued in this round of property reflation.  

Construction cycle: Expect healthy support: The property upturn is lending optimism to the economic outlook.  Not only is the residential private property supply expected to pick up in the next two years or so, the space crunch from the prolonged economic expansion and slow net additions in the past years mean that supply response in the office, retail, factory and warehouse space segments are also expected to show the same pick-up going forward.  Additional support comes from tourism development plans such as the S$7.7 billion development costs of the integrated resorts for which construction starts this year.  Indeed, our calculations show that the healthy construction pipeline will lend about 1-1.5%-pt to headline growth over 2007-2008.  We believe that autonomous support from this end will help improve the growth mix and cushion volatility from the soft-landing in the US economy.  

Wealth impact: Limited housing equity withdrawal; low consumption multiplier Effect for the well-to-do: A unique feature of the household balance sheet in Singapore is that it is ‘asset-rich but cash-poor’.  About 46% of the balance sheet comprise of residential property assets, with the split between private and public property at 47%/53%.  A recovery in property prices should theoretically boost consumer wherewithal.  Indeed, since a few years back, new mortgage products have been introduced that allow households to borrow against the improvement in housing equity.

In practice though, we believe this might be less than common.  Considering how property prices have risen, growth in housing loans has barely moved much from its bottom of 2.1% YoY in October 2006 to 4.8% YoY in April 2007.  We believe that this points to the fact that current homeowners are still not borrowing off the improvement in housing equity.  

Looked at a different way, the absence of leveraging also possibly points to how the current property reflation is being propelled by cash-rich investors with a lesser need to borrow to fund property purchases.  On that point, the real macro impact from capital appreciation for the well-to-do is lower as the consumption multiplier effect is lower.  In addition, the fact that many buyers are foreigners also raises the question of whether capital gains accruing to them are even recycled in the domestic economy.

Inflation: Still subdued: Rented (0.7%) and owner-occupied accommodation (11.1%) takes up 11.8% of the CPI basket.  This means that every 5% rise in ‘rents’ would translate into a 0.6%-pt increase in headline.  (‘Rents’ for owner-occupied accommodation in the CPI basket are based on the annual assessed value provided the Inland Revenue Authority of Singapore.)  Historically, the impact on CPI from property cycles comes through after a 4-6 quarter lag.  Going by how property and rental prices have moved, we could see accommodation price pressures starting to filter through in CPI in 3Q07.  This will largely reflect how HDB prices have come out from negative growth territory rather than private property rental movements because of the skewed public housing ownership (83% of the population are residing in HDB). Going further forward, there appear to be some upside risks from this – rental contracts are typically locked in for a certain tenure, and resets take place over a staggered timeframe.  Hence, the rental growth cycle is usually more muted compared to the property price cycle.  However, in this round of the property boom, rental resets have started to outpace property price increases since three quarters back.

Even then, our calculations show that inflationary pressures from property reflation alone appear to be limited, particularly if the reflation in HDB property is going to be capped.  Although our view on inflationary pressures from property is such, we do believe that inflation could rise above MAS’s 2007 inflation range of 0.5-1.5% in 2H07 from 0.6% in April from factors such as GST hikes.  For 2007 as a whole, we expect inflation of 1.1% YoY.


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