In an update from Morgan Stanley’s Global Strategy Outlook, the analysts find more value in risk assets and  developed markets like the U.S, Japan and Europe over government bonds and emerging markets.

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Risk assets over government bonds

Volatility is increasing relative to the first half of this year as the market transitions away from being supported by expansionary monetary policy, improving growth, and inexpensive valuations to being more focused on fundamentals, growth, and valuation differences between regions and individual securities. Morgan Stanley analysts still favor risk assets, such as stocks and credit over government bonds over the next six months. Equity and non-government bond prices remain reasonable relative to long-term history, and economic growth in developed countries could still surprise to the upside. Even though government bonds are cheaper relative to their peaks earlier this year, they still remain rich relative to the potential downside risk that may be driven by higher bond yields.

Developed market assets preferred over emerging markets

The main risks to Morgan Stanley’s forecast include a sharp increase in bond yields and an abrupt slowdown of emerging market growth. Morgan Stanley analysts are more concerned about a possible hard landing in emerging markets, as there are structural problems that have been brewing over decades and increased financial stress. Structural problems include a gradual loss of competitiveness of emerging market economies, as real exchange rates have risen—making emerging market goods and labor more expensive. Morgan Stanley economists have lowered their economic growth targets by 30 basis points in 2013 to 4.8 percent and by 80 basis points in 2014 to 4.9 percent. Countries such as China have introduced fiscal measures to counteract slower growth and such stimulus might work in the short-term. Morgan Stanley analysts, however, postulate that more far reaching reforms are needed to restore competitiveness to emerging markets in the mid- to long-term.

Equities At Rich End

Emerging markets more vulnerable to volatility

Emerging market assets can experience more volatility in the medium term as they are more exposed to the effect of less expansionary U.S. monetary policy, lower Chinese leverage, and lower emerging market domestic credit. The silver lining is that emerging market sovereign fundamentals have become more diverse and stronger in some countries, particularly as foreign exchange reserves have strengthened. Therefore, Morgan Stanley analysts think that emerging market performance will be differentiated at the country level depending on the strength of the economy and foreign reserves. A widespread emerging market price decline like the one experienced in 1998 is unlikely, in Morgan Stanley’s view.

EM FX Reserves

MS predicts peak of 3.36 percent on USTs

Morgan Stanley analysts forecast the U.S. Treasury bond to peak around 3.36 percent over the next twelve months, and they believe that the bulk of the 2013 bond price correction is over. Regarding Europe, the sovereign debt crisis is unlikely to escalate in the next three to six months but markets are pricing in a bear case in European non-government bonds and equities. Morgan Stanley analysts opine that the European Central Bank may be more accommodating and have upgraded their economic growth expectations for G-10 countries from 1 percent in 2013 to 2 percent in 2014. Developed market assets have more upside potential in this base case than emerging market assets, as economic growth in emerging markets is likely to slow down further.

European, Japanese and U.S. stocks are preferred 

Accelerating global economic growth could underpin developed market equity profits and equity prices. Even though higher bond yields may pose some downside risk, Morgan Stanley analysts believe that such risk is limited. The MSCI World is trading at a 1.95 price to book ratio, which is close to the 73rd percentile of its 20 year range and well below levels registered at the peak of growth cycles in 2003 and 2007.

EM UK cheap Australia US expensive

Morgan Stanley and Citi agree on potential of European equities

Both Morgan Stanley and Citi analysts believe European equities provide the best upside potential in the near to medium term. Citi analysts have upgraded their 2014 GDP growth projections for the Euro Area by 0.9 percent to 0.6 percent. Likewise, they foresee faster growth in the UK increasing their GDP growth forecast by 1.4 percent to 2.1 percent. Equities in the UK and Europe are trading at 13.3 and 16 trailing price to earnings (P/E) multiples, respectively, whereas U.S. equities are trading at more than 16 trailing P/E.

The key to European equity price upside, in Morgan Stanley’s view, is growth in return to equity ratios, which are currently close to 20 year lows. Margins could also expand next year for the first time in three years, according to margin leading indicators that Morgan Stanley uses. Outsized profit growth is not probable as European GDP is not expanding at rates experienced at stronger recoveries, and a slowdown in emerging market growth could restrict sales and profits growth (33 percent of European company sales come from the rest of the world excluding developed markets). Morgan Stanley analysts expect EPS growth of 9 percent for 2014 and 2015.

 Morgan Stanley and Citi disagree on valuation of U.S. equities

Morgan Stanley (NYSE:MS) and Citi analysts are in disagreement with respect to the future direction of U.S. stocks in the next twelve months. On one hand, Citi analysts think that EPS growth forecasts may be cut and that valuations are rich to provide meaningful near-term upside. Citi analysts have downgraded the U.S. from neutral to underweight. Morgan Stanley analysts concede that the consensus forward EPS estimates are higher than their own estimates but they also note that such difference has occurred 29 years out of the 37 years in which EPS consensus estimates have been used. Morgan Stanley analysts believe that the key to forecast future EPS for U.S. stocks is not in whether the consensus is too optimistic but in estimating the probability of a correction.

At this time, Morgan Stanley analysts think that a U.S. equity price correction remains low as U.S. and global economic growth will likely underpin consumption and investment. Consumer confidence is rising as wealth creation accelerates thanks to improvement in housing and stock markets, which in turn could accelerate consumption and favor company sales. The Federal Reserve’s decision to keep asset purchases and accommodative rates intact will also support equity prices and limit yield increases.

Regarding Japan, Morgan Stanley (NYSE:MS) analysts forecast earnings growth for the TOPIX at 25 percent for 2014 relative to year end 2013. This above consensus view is supported by potential yen depreciation driven by accommodative Japanese monetary and fiscal policy to fight deflation and spur investment and consumption. The main factors causing uncertainty for Japanese stocks, according to Morgan Stanley analysts,

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