Time to debunk some conventional wisdom.  When looking at credit markets alone, the consensus opinion of credit investors is often correct, though it can be terribly wrong around major turning points.  The spread rally to date is actually not without precedents in both magnitude and speed based on eight of the past major turning points in credit markets.  And risk-free yields moving higher alone should not trigger expectations of continued spread tightening. 

The battle between U and V.  While the price pattern of US equity markets off of the March lows has resembled a V-shape, this is in the context of the significant de-risking that occurred just after the Lehman bankruptcy, and the sharp re-risking we have seen this year.  On the actual recovery front, our US economics team has pushed up the forecast timeline for a recovery, but given a variety of concerns, expectations are tepid and a U-shape seems more likely than a V.  

We see a positive bias to Europe vs. US because of extreme valuations, but major outperformance may have to wait till later in the next cycle.  We suggest closing any underweight positions in Europe, although we believe European equities are more likely to go down than up in the next 6 months.  Relative valuation vs. US is at bottom of historical range, and sentiment is still downbeat on Europe, while booming liquidity and recovering fund flows may also benefit non-US markets.  

We continue to think that earnings expectations are too high, but some argue that structural changes will allow profits to remain at historically high levels. If so, the outlook for equities would be brighter than we expect.  The first change is the growing reliance on foreign-sourced profits.  Second, unit labor costs have increased less than in prior downturns due to productivity gains.  We still think earnings expectations are too high, but there are signs that we could be wrong.  

Going forward, we believe US external financing will be less assured, posing added risk for the US dollar.  Concern about unsustainably large deficits and debt issuance may increasingly weigh on investor perceptions of US credit-worthiness.  These factors may contribute to higher inflation expectations, which may increasingly be reflected in risk premiums on US assets.  This backdrop raises questions about continued foreign investing in the US over the medium term. 

We raise our MSCI EM target price by 21% to 985 and extend our target price horizon by six months to end June 2010.  Our revised base case earnings forecast is for a slightly shallower and shorter earnings recession than previously. However, we also raise our cash weighting by a further 2% to 5%, as we are tactically cautious here because we assume a lop-sided "W" shape to the underlying economic recovery process, with a near-term setback for key indicators.   

Growing the pie is as important as redistribution.  Despite the slow pace of reforms during F2006-08, positive global factors ensured strong GDP growth.  However, in the current environment where global growth is likely to be subpar, the government will need to move on economic reform.  We expect the government to take a balanced approach, with adequate focus on reviving growth and sending the right signals to the private sector.  

We maintain our cautious view on the market in the near term on the back of rising financial risks.  Although we do not expect any imminent policy tightening by the central bank, despite inflationary concerns globally, Korea's rising yield curve has mixed implications for the market.  We believe the current rise in bond yields is due to the supply glut and inflation expectations globally, rather than a macro turnaround.

We see some near-term upside risks to US economic growth, but they likely will be fleeting and don't change the overriding dynamic of a slow recovery.   Market participants may be encouraged by any positive data and extrapolate them into a more bullish story.  Instead, we would view them as part of the inherently bumpy process of bottoming in the economy, and note that our call for the end of recession is quite different from calling for even a moderately robust recovery.   

We see three phases of a potential Fed exit strategy from quantitative easing - passive, active and rate hikes.  Some of the special liquidity facilities will wind down of their own accord; thus, the ‘passive' exit is already underway.  And we believe the Fed can and should provide specifics about the ‘active' exit.  Finally, the Fed will likely need to adopt tools that allow it to push up policy rates prior to a complete exit from QE. 

GDP estimates cut - for the last time in this cycle, we hope.  On the back of weaker-than-expected 1Q GDP and disappointing April industrial production, we reduced our full-year GDP growth estimate to -4.4%, from -3.3%.  This revision reflects downside surprises in the recent dataflow, but our outlook for the remainder of this year remains unchanged.  We continue to expect GDP growth to turn positive around year-end.

The June Tankan should bring hard evidence that the worst is over.  We expect the headline to pick up fairly dramatically from the worst reading on record in the last survey, while for F3/10 capex we foresee sharp downward revisions by large enterprises for the first time since F3/03 for the June Tankan, resulting in a double-digit decline. Corporate profit plans will likely remain more bullish than our guarded top-down forecast, leaving room for further downward revisions.   

Signs that the worst may be over.  House prices are volatile and clearly have the potential to overshoot any fair value measure on the upside and downside.  But after a 20% house price decline since the peak in summer 2007, there are finally tentative signs that the worst may be behind us.  The most recent housing market activity and pricing data are encouraging and suggest that we may be at an important inflection point.   

In Central Europe there are signs of stabilization in industrial activity.  The improvement in the PMI and the survey evidence suggest that the worst of the inventory drawdown is behind us, and there is scope for industrial activity to stabilize in the coming months.  Given the structure of its economies, we believe that Central Europe - the Czech Republic, in particular - looks best positioned within the EU to benefit from a revival in manufacturing activity. 

We have turned more constructive on the growth outlook for Colombia.  Its economy has not been immune to the global downturn, but we suspect that the worst is now over.  While we still expect the recovery to be below trend, we see room for gains on the currency front as better growth, improved terms of trade and a correction of the overshoot at the turn of the year should push the Colombian peso to appreciate in the months ahead.  

Central bank likely to remain on hold.  We expect inflation to breach the upper border of the price stability band in June at 3.1%, on the back of various one-off factors.  But inflation is likely to return inside the target band almost immediately, and we expect inflation to decline further through November.  Almost regardless of the inflation rate in the short term, we believe that the Bank of Israel will remain on hold at 0.5% during 2009 and well into 2010

Disclosure Statement

The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosure for Morgan Stanley Smith Barney LLC Customers

The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc.  Ask your Financial Advisor or use Research Center to view any reports in addition to this report.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice.  It has been prepared without regard to the circumstances and objectives of those who receive it.  Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice.  The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives.  Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy.  The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors.  Past performance is not necessarily a guide to future performance.  Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete.  We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company.  Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley.  To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates.  Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned.  RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa.   RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data.  The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P.  Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions.  Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley.  Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form.  Additional information on recommended securities/instruments  is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.

STOCK RATINGS

Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell.  Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone.  In any case, ratings (or research) should not be used or relied upon as investment advice.  An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations.

Global Stock Ratings Distribution

(as of May 31, 2009)

For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively.

Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months.

Analyst Stock Ratings

Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.

Analyst Industry Views

Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below.

In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below.

Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below.

Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index.

Important Disclosures for Morgan Stanley Smith Barney LLC Customers

Citi Investment Research & Analysis (CIRA) research reports may be available about the companies that are the subject of this Morgan Stanley research report.  Ask your Financial Advisor or use Research Center to view any available CIRA research reports in addition to Morgan Stanley research reports.  In addition to the disclosures on this research report and on the Morgan Stanley disclosure website (www.morganstanley.com/researchdisclosures), important disclosures regarding the relationship between the companies that are the subject of this report and Morgan Stanley Smith Barney LLC, Citigroup Global Markets Inc. or any of its affiliates, are available at https://www.citigroupgeo.com/geopublic/Disclosures/index_a.html.

This Morgan Stanley research report has been reviewed and approved on behalf of Morgan Stanley Smith Barney LLC.  This review and approval was conducted by the same person who reviewed this research report on behalf of Morgan Stanley.  This could create a conflict of interest.

Other Important Disclosures

Morgan Stanley produces a research product called a "Tactical Idea." Views contained in a "Tactical Idea" on a particular stock may be contrary to the recommendations or views expressed in this or other research on the same stock. This may be the result of differing time horizons, methodologies, market events, or other factors. For all research available on a particular stock, please contact your sales representative or go to Client Link at www.morganstanley.com.

For a discussion, if applicable, of the valuation methods used to determine the price targets included in this summary and the risks related to achieving these targets, please refer to the latest relevant published research on these stocks.

Morgan Stanley Research does not provide individually tailored investment advice.  Morgan Stanley Research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it.  The securities/instruments discussed in Morgan Stanley Research may not be suitable for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser.  The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. The securities, instruments, or strategies discussed in Morgan Stanley Research may not be suitable for all investors, and certain investors may not be eligible to purchase or participate in some or all of them.

Morgan Stanley Research is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or to participate in any particular trading strategy.  The "Important US Regulatory Disclosures on Subject Companies" section in Morgan Stanley Research lists all companies mentioned where Morgan Stanley owns 1% or more of a class of common securities of the companies.  For all other companies mentioned in Morgan Stanley Research, Morgan Stanley may have an investment of less than 1% in securities or derivatives of securities of companies and may trade them in ways different from those discussed in  Morgan Stanley Research. Employees of Morgan Stanley not involved in the preparation of Morgan Stanley Research may have investments in securities or derivatives of securities of companies mentioned and may trade them in ways different from those discussed in  Morgan Stanley Research. Derivatives may be issued by Morgan Stanley or associated persons

Morgan Stanley and its affiliate companies do business that relates to companies/instruments covered in Morgan Stanley Research, including market making and specialized trading, risk arbitrage and other proprietary trading, fund management, commercial banking, extension of credit, investment services and investment banking. Morgan Stanley sells to and buys from customers the securities/instruments of companies covered in Morgan Stanley Research on a principal basis.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel are based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete.  We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a subject company. Facts and views presented in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

Morgan Stanley Research personnel conduct site visits from time to time but are prohibited from accepting payment or reimbursement by the company of travel expenses for such visits.

The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors.  There may be time limitations on the exercise of options or other rights in your securities transactions.  Past performance is not necessarily a guide to future performance.  Estimates of future performance are based on assumptions that may not be realized. Unless otherwise stated, the cover page provides the closing price on the primary exchange for the subject company's securities/instruments.

To our readers in Taiwan:  Information on securities/instruments that trade in Taiwan is distributed by Morgan Stanley Taiwan Limited ("MSTL"). Such information is for your reference only.  Information on any securities/instruments issued by a company owned by the government of or incorporated in the PRC and listed in on the Stock Exchange of Hong Kong ("SEHK"), namely the H-shares, including the component company stocks of the Stock Exchange of Hong Kong ("SEHK")'s Hang Seng China Enterprise Index; or any securities/instruments issued by a company that is 30% or more directly- or indirectly-owned by the government of or a company incorporated in the PRC and traded on an exchange in Hong Kong or Macau, namely SEHK's Red Chip shares, including the component company of the SEHK's China-affiliated Corp Index is distributed only to Taiwan Securities Investment Trust Enterprises ("SITE"). The reader should independently evaluate the investment risks and is solely responsible for their investment decisions. Morgan Stanley Research may not be distributed to the public media or quoted or used by the public media without the express written consent of Morgan Stanley.  Information on securities/instruments that do not trade in Taiwan is for informational purposes only and is not to be construed as a recommendation or a solicitation to trade in such securities/instruments. MSTL may not execute transactions for clients in these securities/instruments.

To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong. If you have any queries concerning Morgan Stanley Research, please contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Hong Kong by Morgan Stanley Asia Limited (which accepts responsibility for its contents); in Singapore by Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H), regulated by the Monetary Authority of Singapore, which accepts responsibility for its contents; in Australia to "wholesale clients" within the meaning of the Australian Corporations Act by Morgan Stanley Australia Limited A.B.N. 67 003 734 576, holder of Australian financial services license No. 233742, which accepts responsibility for its contents; in Australia to "wholesale clients" and "retail clients" within the meaning of the Australian Corporations Act by Morgan Stanley Smith Barney Australia Pty Ltd (A.B.N. 19 009 145 555, holder of Australian financial services license No. 240813, which accepts responsibility for its contents; in Korea by Morgan Stanley & Co International plc, Seoul Branch; in India by Morgan Stanley India Company Private Limited; in Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of Morgan Stanley Research in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin); in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that Morgan Stanley Research has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents.  Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates.  Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned.  RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa.   RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.

The trademarks and service marks contained in Morgan Stanley Research are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data.  The Global Industry Classification Standard ("GICS") was developed by and is the exclusive property of MSCI and S&P.

Morgan Stanley Research, or any portion thereof may not be reprinted, sold or redistributed without the written consent of Morgan Stanley.

Morgan Stanley Research is disseminated and available primarily electronically, and, in some cases, in printed form.

Additional information on recommended securities/instruments is available on request.