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June 06, 2022

Navigating Changing Correlations

June 06, 2022

Navigating Changing Correlations

PATH

Navigating Changing Correlations

June 06, 2022

The US led the rebound in risk assets during the last week of May. However, most markets ended the month flat. The S&P 500 returned 0.2% (USD), the MSCI Europe was down 0.6% (EUR) and MSCI Japan paused its downward trajectory of previous months, ending May up 0.9% (JPY)¹ . The MSCI Emerging Markets Index returned 0.5%1. Energy continued to be the clear sector outperformer with the MSCI ACWI Energy index up 12.2%, on the back of slowly rising oil prices¹. The US 10-Year Treasury yield appears to have finally settled, ending the month a fraction lower than in April, at 2.8% . The VIX moved down to end the month at 26².

The fall in the S&P 500 at the beginning of the month appeared mostly driven by multiple compression. Despite a bounce in the final week, we still believe though this is likely a bear market rally, due to increasing signs of deteriorating consumer confidence and slowing growth. We finally saw the correlation between equities and fixed income turn negative. Should equities fall, investors at least now may have somewhere to hide. Now that the correlation appears to have been restored, we are increasingly comfortable with fixed income and believe the decline in yields should stabilise. With tentative signs that inflation is plateauing, as we progress through the late stages of the cycle, we believe US investment grade credit should outperform high yield credit and equities, especially if recession risks rise. That said, we do not anticipate a US recession until 2H 2023.

Investment Implications

We have been keeping our powder dry, so we can move cash back into markets at opportune moments. We are already seeing opportunities in the fixed income space. In May we maintained our allocation to equities, but deployed cash to increase duration risk by allocating broadly to fixed income. Before the last week of the month, we increased equity exposure via futures, as options deltas had dropped. This is consistent with the team’s view that the market may be oversold in the near term. The subsequent rally in equities in the last week of May indicated our view was correct.

We have made the following tactical changes over May. The implementation of these is dependent on portfolio guidelines and some portfolios may not permit:

High Dividend, Low Volatility Equities

We added an overweight to high dividend, low volatility equities, through an ETF. This offers an attractive dividend yield from US equities, plus exposure to defensive and value sectors, which continue to trade at a discount to growth. The relatively low volatility and beta characteristics should mitigate the downside, in the event of further volatility.

US Equities Enhanced Value

We removed our position in an ETF and moved to Russell 1000 Value futures to take exposure to the value sector more broadly and make room for more focused allocations to other ETFs or mutual funds, for portfolios which have an allocation restriction.

Brazilian equities

We moved from overweight to neutral Brazilian equities. We had moved overweight in April, but the investment case is weakening. Terms of trade have likely peaked in the short term, while prospects for two key exports have deteriorated; soybean prices could come under pressure from higher global supply in 2022/23, while China’s continued zero-Covid policy is likely to hit iron ore demand.

Commodities

We have increased total exposure to commodities, for portfolios which permit, while changing their composition. Within this we have reduced gold, and added a position in an agriculture fund ETF, to gain exposure to agricultural commodity futures. We aim to hedge upside risks to agricultural commodity prices, due to supply disruptions from the conflict in the Ukraine, which is leading to growing food protectionism and rising input costs such as fertiliser, all of which pushes food prices higher.

Emerging Market Local Debt

We moved from overweight to neutral emerging market short-duration commodity-exporter high-yielder countries, implemented through a bond securities basket. Both the key drivers, real yield and terms of trade have deteriorated since we put on the position.

US 10-year Treasuries

We have removed the US 10-year Treasuries underweight. Inflation risks are more balanced, given tentative signs of stabilising wage growth, especially as the global growth outlook dims. Expectations of 50bps Fed hikes in the near term, with several 25bps hikes thereafter, are priced in, leaving little room for a hawkish surprise.

Investment Grade Corporates

We removed our US Investment Grade Corporates underweight and moved to neutral. After recent rates and spreads adjustments, risk-reward in future forward is more balanced as monetary tightening is largely priced in and we see tentative signs of sequential inflation plateauing. Even if recession risks are rising, our analysis suggests higher spreads can be offset by lower rates, leaving an attractive yield. At the same time, we maintained our underweight in European Investment Grade Corporates, as high duration of Investment Grade and compressed spreads are likely to result in poor total returns when yields/spreads rise.

The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.

Tactical Positioning

We have provided our tactical views below:

Source: MSIM GBaR team, as of 31 May 2022. For informational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The tactical views expressed above are a broad reflection of our team’s views and implementations, expressed for client communication purposes. The information herein does not contend to address the financial objectives, situation, or specific needs of any individual investor.

¹ Bloomberg, 1-month return, as of 31 May 2022.

2 Bloomberg, as of 31 May 2022.

RISK CONSIDERATIONS

There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio.

Andrew Harmstone

Managing Director

Global Balanced Risk Control Team

Manfred Hui

Managing Director

Global Balanced Risk Control Team

Global Balanced Risk Control Fund of Funds

ISIN: LU0706093803 | Class Z

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INDEX DEFINITIONS

The indexes shown in this report are not meant to depict the performance of any specific investment, and the indexes shown do not include any expenses, fees or sales charges, which would lower performance. The indexes shown are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

“Bloomberg®” and the Bloomberg Index/Indices used are service marks of Bloomberg Finance L.P. and its affiliates, and have been licensed for use for certain purposes by Morgan Stanley Investment Management (MSIM). Bloomberg is not affiliated with MSIM, does not approve, endorse, review, or recommend any product, and. does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any product.

Exchange-traded fund (ETF): A basket of securities that tracks an underlying index.

MSCI ACWI Energy Index includes large and mid cap securities across 23 Developed Markets (DM) and 27 Emerging Markets (EM) countries*. All securities in the index are classified in the Energy as per the Global Industry Classification Standard (GICS®).

MSCI Emerging Markets Index: The MSCI Emerging Markets Index (MSCI EM) is a free float-adjusted market capitalization weighted index that is designed to measure equity market performance of emerging markets.

MSCI Europe Index: The MSCI Europe Index captures large and mid-cap representation across 15 Developed Markets (DM) countries in Europe.

MSCI Japan Index: The MSCI Japan Index is designed to measure the performance of the large and mid-cap segments of the Japanese market.

MSCI USA Enhanced Value Index: captures large and mid-cap representation across the US equity markets exhibiting overall value style characteristics. The index is designed to represent the performance of securities that exhibit higher value characteristics relative to their peers within the corresponding GICS® sector. The value investment style characteristics for index construction are defined using three variables: Price-to-Book Value, Price-to-Forward Earnings and Enterprise Value-to-Cash flow from Operations

Russell 1000 Value Index: Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

VIX©: This is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 Index options. Often referred to as the fear ndex or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30-day period.

DISCLOSURES

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.

A separately managed account may not be appropriate for all investors. Separate accounts managed according to the particular Strategy may include securities that may not necessarily track the performance of a particular index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required.

For important information about the investment managers, please refer to Form ADV Part 2.

The views and opinions and/or analysis expressed are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time without notice due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively “the Firm”), and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors or the investment team. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific strategy or product the Firm offers. Future results may differ significantly depending on factors such as changes in securities or financial markets or general economic conditions.

This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and the Firm has not sought to independently verify information taken from public and third-party sources.

This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Past performance is no guarantee of future results. Charts and graphs provided herein are for illustrative purposes only.

The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

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