Debt Ceiling Showdown: An Update
May 17, 2011
By David Greenlaw & Ted Wieseman
| New York
A statutory limit on the amount of federal government debt outstanding has been in place since 1917, when Congress enacted the Second Liberty Bond Act. The current limit is $14.294 trillion. Since 1940, the debt ceiling has been increased on 80 separate occasions.
The ceiling applies to almost all federal debt, including: 1) marketable issuance, 2) non-marketable securities (such as savings bonds and special state & local government securities (or SLGS), and 3) debt that the US government owes to itself (such as trust fund obligations for social security, Medicare, civil service retirement, etc.). Thus, the public auctions held by the Treasury on a regular basis are not the sole determinant of growth in the debt subject to limit. Indeed, intragovernmental obligations currently account for nearly one-third of the overall debt subject to limit, and manipulation of these accounts can create additional room to borrow from the market.
In early January, we published a note on the debt ceiling (see The Looming Debt Ceiling Showdown, Greenlaw and Wieseman, January 6, 2011). Since that point, events have played out pretty much according to script. Recently, Treasury Secretary Geithner sent a letter to Congress indicating that the government would hit the current debt ceiling around May 16 (the day the May refunding settles) and would exhaust the usual measures that have been employed in the past to maneuver around the debt ceiling by August 2. The timetable laid out by Geithner is very close to the original estimates contained in our January note. However, we now believe that the Treasury may have a bit more room and could possibly make it to mid-August. The slightly more optimistic borrowing assessment largely reflects the upside surprise seen in the April 15 tax payments by individuals. Based on nearly complete data, we estimate that payments during the 2011 filing season surged about 30% from a year ago. We had been assuming a more modest increase.
We estimate that the so-called ‘extraordinary actions' that Geithner is authorized to deploy amount to about $300 billion and provide a few extra months of borrowing capacity beyond the mid-May deadline. Most of these actions involve bookkeeping entries with no real economic or market impact. The one notable exception is the suspension of SLGS issuance. SLGS are special non-marketable state & local government securities that are issued by Treasury as part of a municipal refunding deal. SLGS issuance was suspended in early May, so any issuer doing a refunding will be forced to defease the outstanding securities by purchasing Treasuries in the secondary market. Recently, gross SLGS issuance has been running at a pace of about $6 billion per month, but it is highly dependent on refunding opportunities in the muni market and thus the level of interest rates.
Some have argued that the Treasury can manage its cash in a way that avoids default. For example, see the Wall Street Journal op-ed's by Senator Pat Toomey and former Treasury official Emil Henry. However, the approach that they are advocating does not seem at all workable to us. The Treasury's cash flows are too lumpy to simply prioritize one form of spending over another. For example, we would expect a significant political outburst if the Treasury withheld monthly social security checks at the beginning of the month (even though there was sufficient cash on hand to make the payments) just in case they needed this cash to make debt service payments at mid-month. Such a scenario is highly impractical - and probably not even legal. Norm Carleton, a former long-time senior Treasury official, has offered a similar criticism of the Toomey/Henry strategy.
Asset sales of gold, student loans and/or MBS by the Treasury represent yet another suggested means of avoiding default. The Treasury has about $125 billion of MBS - which it is in the process of liquidating at a pace of about $10 billion per month (continued sales at this pace are already factored into our borrowing estimates). And, at the current market value of around $1,500/ounce, the US government's holdings of gold are worth nearly $400 billion. The Treasury also has about $400 billion of student loans currently on its books. However, the legal authority for the Treasury Secretary to liquidate the US gold holdings and/or to securitize and sell off its portfolio of student loans is murky at best. Moreover, senior Treasury officials have thrown cold water on the notion that asset sales might be part of the Treasury's strategy. Mary Miller, head of Treasury debt management, recently told Bloomberg News: "A fire sale of financial assets would be damaging to the economy, taxpayers, and financial markets. It would harm the interests of taxpayers, and would undermine confidence in the United States."
So, how might all this play out? From a practical standpoint, there is virtually no chance of a default. The risks surrounding the debt ceiling showdown are more about potential auction disruptions and investor uncertainty, because this is an issue involving willingness rather than ability to pay. If Congress doesn't act to raise the limit on a timely basis, the Treasury could always roll out new - and therefore untested - measures that will extend the authority to issue additional debt. For example, during the 1995-96 experience, Treasury Secretary Rubin declared a 1-year debt issuance suspension period (DISP) in order to disinvest trust fund balances and free up additional marketable borrowing authority. This action was subsequently declared appropriate by government lawyers and the General Accounting Office. Thus, what's to stop a Treasury Secretary from declaring a 2-year or longer DISP and disinvest enough to continue to borrow? At some point, such action might be deemed illegal, but that is likely to come well after the fact. We think this is no way to operate a highly advanced economy such as the US. And, the risk of investor confusion obviously begins to rise as the US political system appears to become more and more dysfunctional. It really boils down to a high-stakes game of chicken.
Path to compromise is foggy. Clearly, this is going to be a tough vote for many members of Congress. Some political insiders are comparing it to the 2008 TARP vote, which seemed to be an important catalyst for the defeat of many members in the House and at least two Senators (Bennett of Utah and Hutchison of Texas). While all the experts agree that a debt ceiling hike will eventually be enacted, the path to a compromise is very foggy at this point. A couple of weeks ago, it appeared that some sort of automatic trigger for budget cuts (possibly a new version of Gramm-Rudman or PAYGO) might be part of a compromise agreement. However, Republican leaders now appear to have shifted gears and are demanding upfront spending cuts that match the requested increase in the debt ceiling. Meanwhile, Democrats still hope to get a clean bill, and the president has reportedly ruled out any form of spending caps.
Basically, negotiations appear to be back to square one. At the end of the day, there will probably be some type of gimmick introduced that yields a compromise agreement. For example, a debt ceiling hike was approved in 2009 only after there was an agreement that a blue-ribbon commission would be established to study the US budgetary situation and make recommendations. The Simpson-Bowles commission did exactly that and presented some thoughtful recommendations aimed at addressing the long-run budgetary imbalance in the US. But these recommendations were summarily dismissed by political leaders on both sides of the aisle who do not want to face the tough choices that are involved in addressing our long-run structural budget deficit.
So, we believe it is appropriate to remain skeptical that there will be any meaningful fiscal policy changes resulting from a deal to hike the debt ceiling. Instead, it's more likely that we will get smoke and mirrors along the lines of the recent resolution to the government shutdown debate. In that instance, Congress delivered a package that claimed $40 billion of budget cuts. However, analysis by the CBO subsequently revealed that the actual savings in F2011 were less than $1 billion.
We continue to believe that meaningful deficit reduction won't occur until the financial markets force the issue. We illustrate in the full report some basic budget math that highlights the problem. On the spending side, healthcare costs have been exploding and are on a path to grow even more rapidly in coming decades. Indeed, under current policies, the CBO estimates that federal government spending, excluding interest on the debt, will amount to nearly 30% of GDP by the middle of this century. While the numbers appear to provide a relatively straightforward indication of where cuts might be needed, the situation becomes much more complicated when political factors enter into the equation. For example, a recent ABC News/Washington Post poll found that 78% of respondents oppose any cuts whatsoever in Medicare. Other polls on this topic have reported similar results. And, after apparently getting an earful from their constituents while they were home for Easter recess, Republicans already appear to be backing away from the dramatic cuts in healthcare spending contained in Budget Committee Chairman Paul Ryan's blueprint.
Meanwhile, on the tax side of the ledger, revenues have tended to fluctuate around 18% to 20% of GDP over the past 50 years or so. Of course, revenues are now well below historical norms because of the recession and prior tax cuts. But, even if ALL of the 2001 and 2003 Bush tax cuts expire at the end of 2012 (as currently scheduled), the payroll tax cut expires at the end of 2011 (as currently scheduled) and the economy achieves full employment, the CBO estimates that revenues will only be around 21% of GDP by 2020. So, we are facing a long-term structural deficit of 10% of GDP or more (after factoring in interest costs). This is the basic arithmetic that points to an unsustainable situation over the long run.
How should investors play the looming debt ceiling showdown? In general, this is a very tough issue for the market to handicap. Here's why: Under one plausible scenario, there is panicked selling of Treasuries because of general investor confusion. For example, at one point during the 1995-96 debt ceiling episode, House Speaker Newt Gingrich appeared on one of the Sunday talk shows and actually stated his willingness to force the government into default (see The Debt Ceiling and Executive Latitude, Bradford and Constadine, Harvard Law School Briefing Paper #11, January 2009). Several months later, he reiterated this position, and press reports at the time suggested that the Speaker's remarks were at least partially responsible for a significant drop in the value of the dollar during one trading session. Although a number of key Congressional leaders have indicated that they will "act like adults" this time round, there is always the possibility that misguided statements by political leaders could prove to be a source of investor concern. Foreign investors might seem to be particular susceptible to confusing statements coming out of Washington. That's important because foreign investors own more than 50% of the privately held Treasury coupon debt outstanding.
Of course, investors have been through debt ceiling showdowns before and should realize that doomsday fears are dramatically overblown. Moreover, we've all just been through a false alarm on a similar fiscal deadlock (i.e., the government shutdown).
Under an alternative scenario, investors realize that there is essentially zero risk of default. Also, there may be hope that a debt ceiling compromise could include some meaningful deficit reduction. Most importantly, we may be headed for a situation in which Congress grants a series of short-term extensions to the debt ceiling, leading the Treasury to postpone coupon auctions and replace the issuance with cash management bills. Indeed, Treasury officials appear to be preparing for just such a scenario. Mary Miller, the current head of debt management at the Treasury Department, delivered a carefully worded statement along these lines at the May refunding announcement. So, we could see a significant amount of duration being taken out of the market for a period of time - which would amount to a quasi-QE3.
Also, as mentioned previously, the suspension of SLGS issuance would imply the potential for some secondary market demand for long-duration Treasuries from municipal issuers. Obviously, this type of supply/demand shift could trigger a rally in long-dated fixed income. Moreover, risky assets would benefit under the Fed's portfolio balance model of QE (i.e., taking duration out of the Treasury market pushes investors into riskier asset classes).
We've outlined two dramatically different market scenarios - one in which the debt ceiling debate triggers fear and uncertainty, leading to higher yields, and the other in which the supply/demand fundamentals help to drive rates lower. This is one of those issues in which anyone who has a basic understanding of the key issues can make their own assessment on the basis of how they think investors will behave.
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Review and Preview
May 17, 2011
By Ted Wieseman
| New York
Treasuries ended the past week little changed after trading back and forth in moderate ranges (15bp through the week for the 5-year), as a rise in real yields was offset by a decline in inflation expectations. Market focus was largely on the refunding auctions, with the week's lows hit early Wednesday ahead of the 10-year auction, followed by a move to the week's best levels Wednesday afternoon and into overnight trading Thursday following the strong 10-year results, but then a pullback Thursday afternoon following the softer 30-year sale. There has been persistently solid underlying real money long-end demand recently, so the soft 30-year auction results were somewhat surprising, but buying quickly emerged at the post-auction lows, and the gains were added to Friday once the CPI report was out of the way with elevated but as-expected results.
Though commodity prices rebounded on net slightly from the severe losses seen May 5 and 6 after substantial back-and-forth swings, the reverberations from the big drop in oil and gasoline prices from the highs hit at the end of April continued to weigh heavily on TIPS and inflation breakevens, especially at the short end. Average regular retail gasoline prices hit $3.96 in the week of May 9, and futures markets continue to suggest that this is very close to the peak. Indeed, it now appears that the run-up in retail gasoline prices in May might actually trail the normal seasonal gain of about 5%, which could leave seasonally adjusted headline CPI near the underlying core trend of a bit below +0.2% after a run of +0.4% and +0.5% headline CPI gains from December through April. TIPS are valued based on the not seasonally adjusted CPI index, which saw a big further 0.6% rise in April and will probably rise about 0.4% in May, so TIPS returns from inflation accrual should run at over 6% annualized in June and July. The $0.30 a gallon plunge in the December gasoline futures contract to $2.75 in the past two weeks, however, points to retail gasoline prices pulling back to below $3.50 a gallon by year-end from a near-term peak near $4.00. On a year-on-year basis, this would result in a moderation in gasoline price inflation to near +15% in December from a peak near +40% from May through September. Gasoline prices are about 5% of CPI, so this would shave the gasoline boost to headline CPI inflation from a near-term high of 2pp to a boost near 0.8pp by year-end, though we expect that this will be partly offset by a further rise in core inflation and food prices, leaving overall CPI near +3.3% in December versus +3.2% in April after an interim high near +4% in September. The hit to consumer spending power from such a moderation in gasoline inflation would fall from a near-term peak near $125 billion on an annual basis to about $50 billion by year-end. This is an important driver - along with an expected ramping up of auto production later in 3Q and into 4Q after temporary ongoing disruptions from parts shortages, continued strengthening in equipment investment with an extra boost from the tax incentives that expire at year-end, and a positive seasonal swing in net exports - of our outlook for an acceleration in GDP growth to +4% in 2H from +2.5% in 1H.
On the week, benchmark Treasury yields all ended up about unchanged, with minor gains in the short and intermediate parts of the curve and minor losses at the long end. The 2-year yield fell 1bp to 0.54%, old 3-year 1bp to 0.92%, 5-year 2bp to 1.85% and 7-year 1bp to 2.52%, the old 10-year yield was unchanged at 3.15% and the old 30-year yield rose 2bp to 4.31%. The new issues all ended in the green after mixed auction results, with the 3-year closing at 0.96% after being auctioned Tuesday at 1.00%, 10-year ending at 3.18% after being auctioned Wednesday at 3.21% and 30-year ending at 4.32% after being auctioned Thursday at 4.38%. This stability in nominal yields reflected higher real rates being fully offset by lower inflation expectations. June oil rose $2.47 a barrel on the week to $99.65, though after trading as high as $104.60 Tuesday night, but June gasoline marginally extended the sharp drop seen the prior week, falling another $0.02 to $3.07, and the dollar added to the gains that accompanied the initial plunge in oil prices. The CPI and PPI reports were elevated in April, with big energy gains driving elevation in the headline readings, while core PPI and CPI both extended their recent turns higher. Core PPI has risen to +2.1% in April from +1.1% in June, while core CPI is now up to +1.3% from the low of +0.6% in October. Against these somewhat mixed seeming signals, TIPS, especially at the short end, were under pressure most of the week, with the 5-year yield rising 9bp to -0.35%, 10-year 7bp to 0.75% and 30-year 7bp to 1.77%, which dropped the benchmark 5-year breakeven 11bp to 2.19%. The further pullback in short-end breakevens was larger, about 20bp in the 2-year sector, and was smaller at the long end, resulting in a significant steepening in the inflation breakeven curve to a pretty flat structure now, ranging only from a little above 2% expected inflation in the 1-year area to a bit above 2.5% for the 30-year breakeven.
Risk markets also ended up little changed, with a soft performance Friday leaving the S&P 500 down 0.2% for the week, the investment grade CDX index flat at 90bp, and the high yield CDX index slightly tighter near 435bp. Along with the further short end-led pressure on TIPS, energy and materials stocks continued to be hurt by the prior decline in commodity prices even with some stabilization over the past week, with the energy sector down 1.4% and materials 1.9%. Financials, industrials and tech stocks also fell, while the consumer staples, healthcare and utilities sectors posted goods gains near 2% in a continued rotation into defensive areas. A significant further softening in the euro on the week to $1.410 from $1.432 (and $1.483 at the close on May 4 before the ECB meeting) came despite improvement in peripheral EMU spreads. Portugal's 5-year CDS spread narrowed about 30bp to near 620bp, the low in a month, as Finland signaled that it would not block approval of the bailout plan, and Ireland's spread came in about 40bp to near 640bp. There was a bit of pressure on muni CDS, however, after a move to the best levels in a year in recent weeks. The 5-year MCDX index widened 6bp to 125bp on the week, still 92bp better year to date.
Growth data released over the past week were mixed and had limited market impact. Incorporating data on wholesale inventories, international trade, retail sales, retail inventories, CPI and annual revisions to manufacturing shipments and inventories, we continue to see 1H GDP growth running at +2.5%. The quarterly pattern looks much flatter now, however. Coming into the week we were looking for a slight downward revision to 1Q GDP growth to +1.7% from +1.8%, and we saw 2Q growth tracking at +3.3%. Now we look for 1Q to be revised up to +2.1%, and we see 2Q tracking at +2.9%. Adding to 1Q were upside in wholesale and retail ex auto inventories and the trade balance relative to what BEA assumed in preparing the advance 1Q estimate, an upward revision to underlying retail sales in March, and slightly strong quarterly growth in capital goods shipments in 1Q in the annual revisions to the durable goods orders figures.
The revised monthly pattern for capital goods shipments also provided a stronger ramp for investment coming into 2Q, and we boosted our 2Q forecast for equipment and software investment to +9% from +8%. But a wider-than-expected real trade deficit in March lowered our forecast for the trade contribution to 2Q GDP growth to -0.3pp from +0.1pp, while the lower-than-expected 0.2% April gain in the key retail control grouping (sales excluding autos, gas and building materials) in the retail sales report, partly offset by a slightly lower forecast for headline PCE inflation after incorporating the PPI and CPI data, lowered our 2Q forecast for consumption to +2.3% from +2.5%. The sluggishness in 2Q trade and consumption are largely expected to result from temporary special factors that should be reversed in 2H. We now see real exports and real imports both rising about 10.5% in 2Q. The upside in exports would extend the strong 11% annualized growth posted in the seven quarters through 1Q, in line with continued indications of solid ongoing global GDP growth. About half of the import surge we forecast for 2Q, however, comes from statistical issues. BEA's seasonal adjustment of oil import prices has resulted in a very volatile but very predictable quarterly pattern over the past five years, with oil imports showing unusual strength in 2Q and 3Q (2Q especially) and then seeing a corrective plunge in 4Q. On average from 2006-10, real oil imports posted reported growth of +26% (ranging from +13% to +60%) annualized in 2Q and 3Q and then an average plunge of 36% (ranging from -15% to -55%) in 4Q. Last year saw the worst volatility yet, with a 78% rise in 2Q, a further 44% rise in 3Q, and then a 55% plunge in 4Q. Monthly figures through March suggest we could see nearly as big a rise in 2Q11 as in 2Q10 before another substantial correction in 4Q. At this point, we forecast a 68% rise in real oil imports in 2Q (with further upside in 3Q but then a big correction again in 4Q), which accounts for half of the 10.5% gain we expect in overall real imports in 2Q.
Meanwhile, the lower-than-expected gain in April retail control, even with the upward revision to March, showed a softer gain over the March/April Easter shopping period than implied by strong chain store sales results. We suspect that April will probably get revised higher next month, just as March, February and January have been in the next reports. Even without a revision, underlying retail sales are up at a strong 8% annual rate in the three months through April and should see good upside for all of 2Q. Instead, the main negative we see for 2Q consumption is a shortage of retail auto inventories. April auto sales held up surprisingly well even with automakers reducing sales incentives as production disruptions lowered inventories. But disruptions to production resulting from shortages of parts from Japanese suppliers are expected to deplete inventories enough to have a material negative impact on sales - and further boost prices - in May and into the summer. This is likely to be followed by a sharp ramping up in production and accompanying improvement in sales during the second half of the year as the supply disruptions are resolved.
The economic calendar is fairly light in the coming week. Early expectations for the next manufacturing ISM report will be guided by the Empire State manufacturing survey released Monday and Philly Fed on Thursday, and jobless claims this week will cover the survey period for the May employment report. After the strongest four-month run since 1984 for the manufacturing ISM, another elevated reading in the composite MSBCI index points to another good month for the ISM (see US Economics: Business Conditions: Disconnects Widening, May 13, 2011). The overall sentiment index in the MSBCI softened in April to 49 from 55, but the composite gauge of activity measures only dipped to a still very strong 68 from 70, and the MSBCI composite index has tracked the ISM quite well over the past year. On the other hand, while there have been some special factors driving recent elevation, the 4-week average of initial jobless claims has moved up a fair amount since the April survey week, so we could see some moderation in May non-farm payrolls growth after the upside surprise in April. On the Fed calendar, a number of speeches by regional bank presidents are scheduled, including several from dovish New York Fed Chairman Dudley. The minutes from the April FOMC meeting will be released on Wednesday. The importance of the minutes is greatly diminished by Fed Chairman Bernanke's post-meeting press conference and discussion of the FOMC forecasts compiled at this meeting. CNBC reported, however, that there was a more lively debate about exit strategy at the meeting than was reflected in Chairman Bernanke's remarks, so it will be interesting to see if this is reflected in the minutes. On the fiscal policy front, settlement of this week's Treasury auctions on Monday will require Secretary Geithner to begin implementing extraordinary accounting measures under a "debt issuance suspension period" in order to make room under the current debt ceiling. We estimate that unusual accounting maneuvers can free up about $300 billion in additional temporary borrowing room. Even with an upside surprise in April non-withheld tax receipts and some expected TARP repayments in coming weeks, we estimate that this will only last until early August, and that the debt limit will have to be raised in order to settle the August refunding auctions on August 15. While we believe that the chances of an outright default are negligible, the potential for auction disruptions and broader market volatility are high, in our view (see US Economics: Debt Ceiling Showdown: An Update, May 13, 2011, for details).
Other data releases due out in the coming week include housing starts and industrial production Tuesday and existing home sales and leading indicators Thursday:
* We look for a modest rise (+4.7%) in housing starts in April to a 575,000 unit annual rate as weather conditions across much of the US turned normal following an unusually severe winter. From a broader perspective, housing starts have been bouncing around with a relatively narrow range since late 2008. We expect this pattern to continue for the foreseeable future. By our estimate, it will take another two years or so to absorb the oversupply of unoccupied residential units that exists at present.
* We forecast a 0.7% gain in April industrial production. The employment report pointed to a solid rise in factory output for the month of April. In fact, the gain would be even larger were it not for a sharp drop-off in motor vehicle assemblies tied to supply chain disruptions. We look for the key manufacturing component of IP to be +0.7% in April - just about matching the sharp gains seen in recent months. Excluding motor vehicles, manufacturing output is expected to be up by a whopping 1.1%.
* We expect April existing home sales to rise to a 5.25 million unit annual rate. The pending home sales index posted a modest rise in March. Also, mortgage application volume has improved a bit of late. So, we look for April resale activity to be up about 3% versus March. We will update our estimate if there are surprising results from the regions that report before the release of the national data.
* Based on available components, the index of leading economic indicators is likely to be flat in April after surging at an 8% annual rate over the prior six months. Negative contributions from jobless claims and supplier deliveries should be about offset by positive contributions from the yield curve, consumer confidence and stock prices.
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