>CROSS-ASSET STRATEGIES (MORGAN STANLEY)

The end of easing

What to expect as policy makers reverse

Risk assets are in the sweet spot. Investors see looming recovery but policy remains at recession-combating levels. The focus will soon turn to the end of easing and, beyond that, the policy tightening phase.

We expect a below-par recovery. So while easing may soon end, tightening will probably not start until 2010 – well into 2010 for many developed economies. Markets, however, look ahead, and when the focus turns to a prospective tightening, we think investors should:

• Sell equities as the strong relief rally is partly reversed. We expect developed equities to settle into a wide range-trading environment for an extended period. Emerging market equities will likely remain high beta, but we expect medium-term structural outperformance to continue.

• Rotate into late cyclicals and quality defensives. Also expect market performance to increasingly reflect the divergent outlook for domestic growth in various regions.

• Buy forward volatility in rates, and expect still-steep curves. End of easing increases volatility for rates, while the curve is likely to be structurally steeper than in the prior cycle. In equity derivatives, we like positioning this view directly via variance swaps, and directionally via diagonal put spreads.

• Buy EM currencies and reflation laggards (SEK in G10, KRW in EM). Currency markets will focus on fiscal strength and high beta/high rate currencies that have lagged to date.

• Stay long credit, but expect lower returns. The big risk to credit is double-dip, not the end of easing.

To see full report: CROSS-ASSET STRATEGIES