MORGAN STANLEY RESEARCH - L'Agefi Actifs · MORGAN STANLEY RESEARCH March 5, 2014 ContagEM Contributors to this Report The contributors to this report are opining only on their respec

March 5, 2014

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M O R G A N S T A N L E Y B L U E P A P E R

ContagEM Could it be worse than the 1990s for DM?

Are developed market economies still resilient to an emerging markets shock? DM economies sailed through half a decade of EM sudden stops in the late 1990s. That resilience is unlikely to be repeated today, should an EM shock materialize. A larger EM and China footprint in the global economy, much greater DM exposure to EM via exports and financial linkages, and a weaker starting point for DM growth could collectively pass on a stronger variant of contagEM to DM growth and markets than was seen back then.

How would DM economies react to an EM shock today? An EM shock would create an average drag of 1.4% for four quarters on US growth, and the euro zone and Japan would likely slip into recession. Lower commodity prices and lower bond yields (thanks in part to easing from the Fed and the BoJ) would then revive growth, but the recovery is likely to be weak, given the poor starting point and constraints on policymakers.

Most exposed are European equities (relative to the US and Japan), the euro and commodities, while DM bonds and gold would be safe havens. Corporate revenue exposure to EM and the weak economic starting point make the European equity and FX markets vulnerable relative to their peers. EM has also driven the demand for industrial metals and oil, which puts these assets at risk. On the other hand, slower growth, policy action and a safe-haven bid would push up bonds. Gold would win too.

Conclusion: If an EM shock materializes, we believe the impact on DM could be stronger than it was in the late 1990s and would most likely last longer.

M O R G A N S T A N L E Y R E S E A R C H

G l o b a l

Manoj Pradhan1

Chetan Ahya2

Graham Secker1

Paolo Batori1

Global Economics

US Economics

Europe Economics

Japan Economics

Australia Economics

New Zealand Economics

AXJ Economics

Latin America Economics

CEEMEA Economics

Europe Equity Strategy

Japan Equity Strategy

US Equity Strategy

EM Equity Strategy

FX Strategy

US Interest Rates Strategy

Europe Interest Rates Strategy

US Interest Rates Strategy

EM Interest Rates Strategy

US Credit Strategy

Europe Credit Strategy

EM Credit Strategy *See page 2 for all contributors to this report

1 Morgan Stanley & Co. International plc+ 2 Morgan Stanley Asia Limited+

Morgan Stanley Blue Papers focus on critical investment themes that require coordinated perspectives across industry sectors, regions, or asset classes.

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March 5, 2014 ContagEM

Contributors to this Report

The contributors to this report are opining only on their respective areas of coverage. Their views are clearly delineated in the sub-sector contributions to this report. Manoj Pradhan and Chetan Ahya are Economists. Paolo Batori is a Credit Strategist. Graham Secker is an Equity Strategist.

Economics

Manoj Pradhan2 +44 (0)20 7425 3805 [email protected] Sung Woen Kang2 +44 (0)20 7425 8995 [email protected] Patryk Drozdzik2 +44 (0)20 7425 7483 [email protected] Philipp Erfurth2 +44 (0)20 7677 0528 [email protected] Ellen Zentner1 +1 212 296 4822 [email protected] Ted Wieseman1 +1 212 761 3407 [email protected] Elga Bartsch2 +44 (0)20 7425 5434 [email protected] Daniele Antonucci2 +44 (0)20 7425 8943 [email protected] Olivier Bizimania2 +44 (0)20 7425 6290 [email protected] Robert Feldman6 +81 3 5424 8400 [email protected] Takeshi Yamaguchi6 +81 3 5424 5404 [email protected] Daniel Blake4 +61 2 9770 1579 [email protected] Chetan Ahya5 +852 2239 7812 [email protected] Derrick Kam5 +852 2239 7826 [email protected] Sharon Lam5 +852 2848 8927 [email protected] Jason Liu5 +852 2848 6882 [email protected] Upasana Chachra8 +91 22 6118 2246 [email protected] Deyi Tan3 +65 6834 6703 [email protected] Zhixiang Su3 +65 6834 6739 [email protected] Gray Newman1 +1 212 761 6510 [email protected] Arthur Carvalho7 +55 11 3048 6272 [email protected] Luis Arcentales1 +1 212 761 4913 [email protected] Daniel Volberg1 +1 212 761 0124 [email protected] Tevfik Aksoy2 +44 (0)20 7677 6917 [email protected] Jacob Nell9 +7 495 287 2134 [email protected] Alina Slyusarchuk2 +44 (0)20 7677 6869 [email protected] Pasquale Diana2 +44 (0)20 7677 4183 [email protected] Michael Kafe2 +27 11 587 0806 [email protected] Andrea Masia10 +27 11 282 1593 [email protected]

Strategy

Graham Secker2 +44 20 7425-6188 [email protected] Jonathan Garner5 +852 2848-7288 [email protected] Adam Parker1 +1 212 761-1755 [email protected] Hans Redeker2 +44 20 7425-2430 [email protected] Matthew Hornbach1 +1 212 761 1837 [email protected] Anthony O’Brien2 +44 20 7677-7748 [email protected] Jesper Rooth2 +44 20 7425-4740 [email protected] Ashley Musfeldt1 +1 212 761-1727 [email protected] Andrew Sheets2 +44 20 7677-2905 [email protected] Adam Longson2 +1 212 761-4061 [email protected] Joel Crane4 +61 3 9256-8961 [email protected] Viktor Hjort5 +852 2848-7479 [email protected] Rashique Rahman1 +1 212 761-6533 [email protected] Paolo Batori2 +44 20 7677-7971 [email protected] Vanessa Barrett2 +44 20 7677-9569 [email protected] James Lord2 +44 20 7677-3254 [email protected] Simon Waever2 +44 20 7425-1640 [email protected] Due to the nature of the fixed income market, the issuers or bonds of the issuers recommended or discussed in this report may not be continuously followed. Accordingly, investors must regard this report as providing stand-alone analysis and should not expect continuing analysis or additional reports relating to such issuers or bonds of the issuers.

1 Morgan Stanley & Co. LLC 2 Morgan Stanley & Co. International plc+

5 Morgan Stanley Asia Limited+ 6 Morgan Stanley MUFG Securities Co., Ltd.+

9 OOO Morgan Stanley Bank 10 RMB Morgan Stanley (Proprietary) Limited

3 Morgan Stanley Asia (Singapore) Pte. 7 Morgan Stanley C.T.V.M. S.A. 4 Morgan Stanley Australia Limited 8 Morgan Stanley India Company Private Limited

See page 73 for recent Blue Paper reports.

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Table of Contents

Executive Summary .............................................................................................................................................................. 4

ContagEM: Could it be worse than the late 1990s for DM? ...............................................................................................

How are things different from the 1990s? ........................................................................................................................ 6

The EM shock .................................................................................................................................................................. 8

Why DM is more exposed this time around...................................................................................................................... 10

The impact – could it be worse than the 1990s?.............................................................................................................. 12

ContagEM Chartbook............................................................................................................................................................ 14-22

Economics .............................................................................................................................................................................

US: Domestic growth and policy reaction mitigate impact................................................................................................ 24

Euro Area: Modest EM exposure still makes for recession risk ....................................................................................... 27

Japan: Ups and downs – mostly downs ........................................................................................................................... 29

Australia & New Zealand: Hit to exports and expectations............................................................................................... 31

Asia ex Japan: High direct exposure to China ................................................................................................................. 34

Latin America: Commodity price linkages are key............................................................................................................ 36

CEEMEA: Less directly exposed to China’s growth slowdown ........................................................................................ 38

Strategy..................................................................................................................................................................................

Equity Strategy: Europe most exposed in DM.................................................................................................................. 41

DM FX: EM contagion lifts USD and JPY......................................................................................................................... 57

EM FX: ContagEM would accelerate downward adjustment............................................................................................ 60

Global Rates: DM bonds will be safe havens, EM rates will adjust higher ....................................................................... 62

Global Credit: US and Europe credit less exposed than equities, EM credit tied to China............................................... 65

Commodities: At risk, but not 2008 redux ........................................................................................................................ 68

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ContagEM: Executive Summary

An emerging markets shock comparable to what we saw in the late 1990s could hurt developed markets, and would most likely hurt DM growth more than it did back then. Both growth and markets would probably take much longer to recover than they did in 1997-98.

But why are DM economies more vulnerable to an EM shock today? For three reasons:

The footprint of EM, and particularly China, on the global economy, the supply chain and trade is bigger now than it was in the 1990s.

DM economies have become more exposed to EM via exports, corporate revenues, banking and via DM portfolios.

The DM starting point is weaker. Growth is more brittle, deflation concerns persist, and domestic demand is a less powerful driver of growth, leaving DM growth and markets exposed to a deflationary shock via external demand.

In this Blue Paper, our objective is to provide investors with a framework for understanding ContagEM to DM:

We provide a measure of the sensitivity of DM growth to an EM shock.

We examine the channels through which DM markets are exposed to EM and list the most exposed assets and the safe havens.

We seek to provoke some discussion on asset allocation questions, including the potential for EM outperformance over DM in the medium term.

To focus purely on the effects of the EM shock, we restrict our analysis to ‘first round effects’, in other words, only the direct effects from EM on DM. We do not consider the second-round effect of lower DM growth on domestic markets.

We model an EM shock scenario by considering three triggers for ContagEM:

1. A 15% decline in EM imports for two quarters before a modest recovery

2. A deterioration in financial conditions similar to that during the late 1990s

3. Weaker commodity prices, including oil prices falling to around US$80/bbl, before a gradual recovery

How does the EM shock impact DM growth?

1. The US would see an average quarterly drag of 1.4% in the first four quarters after the shock, we estimate. With a better starting point than Europe or Japan (higher growth, stronger domestic demand), and help from the Fed and lower commodity prices, we expect US growth to do relatively better.

2. The euro area would likely slip into recession, with tailwinds from a weaker euro, lower bond yields and lower oil prices helping. The shock to external growth with weak domestic demand could mean that deflation concerns resurface.

3. Japan, too, could see recession and find itself in a harder fight against deflation, despite recent success. The BoJ would likely respond, and lower commodity prices would help Japan much more than other DMs, given the legacy of the Fukushima incident.

4. Australia and New Zealand, in contrast, would suffer from lower commodity prices, and would most likely need policy help to support growth.

How does EM exposure affect DM markets?

Equity European equity markets are likely to be more adversely affected than the US and Japan. European corporates have derived 65-80% of their revenue growth from EM in recent years, thanks to weak domestic growth. Overall, 33% of European corporate revenues come from EM. The US and Japan have much lower numbers on both fronts (the EM contribution to revenue growth is falling in the US, and Japan’s corporates generate only 12% of their revenues from EM). EM corporates too have varying exposure, with Malaysian, Indonesian and Thai corporates deriving over 90% of their revenues from EM.

Most exposed sectors? In Europe – energy, materials, technology and staples. In the US – technology, energy, materials and industrials. In Japan – materials, consumer

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discretionary, technology, energy and industrials. See also the stock screens for the most EM-exposed names in the US, euro area, Japan and EM on pages 51-56.

FX The deflationary pressures from an EM shock would likely push the USD and JPY higher, while EUR could reach 1.18 in a ContagEM scenario. Although USDJPY could initially fall, the BoJ’s actions would likely mean that the cross would not stay offered for long. EM FX has been adjusting for a while now, but could still see 8-10% declines, with the ruble probably most affected on worsening fundamentals.

Credit US and European credit markets are less exposed than their equity cousins because of the pattern of issuance – a large chunk of issuance comes from sectors with a domestic revenue base. Most exposed? In Europe – energy, materials, autos, chemicals; In the US – basics and energy.

Commodities Industrials metals would suffer further, while Brent could dip to

US$80/bbl. Gold would be the clear beneficiary, thanks to flows from safe-haven seeking investors.

Rates G4 bond yields would likely fall thanks to weaker growth, policy action and a safe-haven bid. EM bonds would probably suffer due to higher risk premia.

What are the asset allocation implications?

Bonds would most likely outperform everything else, with the possible exception of gold.

Hard commodities, oil, EM and European equities and the euro would probably perform worst in this scenario.

EU equity market and FX weakness present a worrisome combination. USD strength – reflecting the resilience of the US economy and the relatively lower EM exposure of US equities – would help support risk sentiment in the US. EM credit is already under pressure, and pain in China’s credit market could aggravate conditions in other credit markets in EM.

Exhibit 1

ContagEM Playbook: What do to if an EM shock materializes

Equities (page 41)

Sell European equities over US and Japan: European corporates are far more exposed to EM than are US and Japanese corporates.

Sell EM exposed sectors: In Europe – energy, metals, technology and staples; in the US – technology, energy, materials and industrials; in Japan – materials, consumer discretionary, technology, energy and industrial sectors.

Sell EM exposed stocks: our equity strategy team presents stock screens for EM exposure for European, US, Japanese and EM equity markets on pages 51-56.

FX (page 57)

Sell EURJPY to 107: USD and JPY will both rally in a ContagEM scenario, while EUR is likely to fall. EURJPY is the best expression of these dynamics. Selling NOKJPY is an attractive alternative.

Rates (page 62)

Buy core DM government bonds on slower growth, monetary easing from the Fed and the BoJ, and a safe-haven bid.

Credit (page 65)

Sell EM exposed sectors.

In Europe, sell energy, materials, autos and chemicals as 40% or more of their revenues come from EM.

In the US, sell energy and basics vs. utilities given the EM exposure of energy and basics and the heavy domestic exposure of the utilities sector.

Commodities (page 68)

Sell Brent to US$85-90/bbl on the drop in real demand from EM, while keeping a lookout for the supply response to falling prices. Brent could fall further, but that would need seasonal effects to pitch in.

Sell iron ore to US$80/t and copper to US$5,000/t: Iron ore is already in oversupply and subject to downside risks, and copper is likely to be sold by investors as it is trading furthest above its cash cost.

Buy gold: Safe-haven flows could take gold to its 2013 average, and perhaps higher. Source: Morgan Stanley Research

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ContagEM: Could it be worse than the late 1990s for DM?

How are things different from the 1990s?

Amplifiers and Dampeners

The EM Shock

A Sudden Stop or a China Shock

Calibrating the EM Shock

Why DM is more exposed this time around

Starting points are weaker

Real links (exports and corporate revenues) are stronger

Financial links are too (banking exposure, DM portfolios)

The impact – could it be worse than the 1990s?

Where is growth most at risk?

Which markets and asset classes are most affected?

What could it mean for asset allocation?

Back in the 1990s, developed market economies sailed through what was one of the worst decades for emerging market economies. Between 1994 and 1998, Turkey, Mexico, Argentina, Thailand, Malaysia, Philippines, Indonesia, Korea, Russia and Brazil all suffered a sudden stop in capital flows and financing, and sharp drops in asset prices, currency values and output. Yet, the US and German economies shrugged off the shock to exports. Markets did not fare as well. The VIX doubled, the S&P 500 fell more than 20% and bond yields fell 150bps. Asset prices in Germany and Japan fell sharply too. However, because of a strong starting point (which supported EM exports) as well as the small footprint of EM in the global economy, DM markets recovered quickly, and DM growth emerged unscathed.

Clearly, EM is no longer a side-show. China alone is enough to put paid to that argument. Many, including ourselves, see parallels to the 1997-98 scenario: DM economies doing well, with the consequent rise in DM real rates and currency values hurting EM economies and raising the risk of a sudden stop.

Yet, given how big the EM footprint is today, is it still reasonable to assume that DM economies would go unscathed through a potential EM shock? In this Blue Paper, we ask: If an EM shock plays out again, could it be worse for DM economies this time compared to the late 1990s?

Sir Humphrey Appleby’s droll remark in the celebrated political satire Yes Minister, “as long as you are not asking me to resort to crude generalizations and vulgar simplifications such as a simple yes or no, I shall do my best to oblige”, has historically guided politicians and economists alike.

Breaking with that grand tradition, we say “yes”. If an EM shock materializes, we believe contagion to other EM economies and then on to DM growth and to markets could have a bigger and certainly longer-lasting impact on DM growth and markets than we saw in the late 1990s.

How we calibrate a ContagEM scenario. We argue that a sudden stop in the ‘Double Deficit Club’ economies1 or a China shock would feed into DM economies via three triggers:

1. A 15% decline in EM imports over two quarters followed by a gradual recovery

2. Higher market volatility akin to the late 1990s

3. Lower commodity prices, with oil prices falling to around US$80/bbl and then moving back up slowly

In this Blue Paper, we look at the potential impact on DM economies and on asset classes. We restrict our analysis to ‘first round effects’, in other words, only the direct effects from EM on DM. We do not consider the second-round effects of lower DM growth on domestic markets.

We view the DM growth estimates from our economists as ‘sensitivities’ rather than predictions, while our strategy teams have focused on identifying the channels of exposure in DM markets. Our objective is to provide investors with a framework for understanding ContagEM to DM now compared with 1997-98.

Today versus the 1990s: what’s similar and what’s different?

Despite our unambiguous statement above, the risk of an EM shock is still itself a risk. There are several factors that are keeping that risk from materialising. These are essentially ‘dampeners’ or shock absorbers that are pushing the global economy towards a stable equilibrium. Working the other way

1 Brazil, Turkey, South Africa, to a lesser extent India, Indonesia, with

Russia and Thailand ‘applying’ for membership

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are ‘amplifiers’ – factors that will tend to aid the course of ContagEM and exacerbate the impact of an EM shock on to DM economies. The balance between the two will decide whether the link between EM and DM will be tested.

Dampeners: what’s keeping an EM shock at bay?

1. Constructive global environment and DM resurgence: After half a decade of bumpy, below-par and brittle growth, DM economies have taken the lead in driving global growth over the past year as growth continues to pick up. Monetary policy from the major central banks will remain highly expansionary for a long time, providing support to that recovery.

Trend growth in DM is, however, lower in the aftermath of the crisis, but we are unsure whether this acts as a dampener in EMs’ favour. On the one hand, weaker trend growth means that DM real rates will not rise as fast to very high levels, and that’s good for EM economies that need external funding. Yet, on the other hand, DM economies have taken on growth strategies that do not really benefit EM economies via the traditional export line2. The US, in particular, looks more like a competitor for EM economies than the traditional consumer it has been.

2. Some stabilizing factors in EM: EM economies are more resilient than in the 1990s. There are two main dampeners at work here: (i) EM institutions are more resilient. Most important, the adoption of flexible exchange rate regimes has allowed continuous adjustment rather than a delayed and sharp adjustment through devaluation, as was the case in the past. It should be noted that EM FX can help transmit shocks to other asset classes and economies in times of extreme stress, but flexible rates have generally helped. (ii) Domestic macro-stability and fundamentals are better, particularly on the inflation front, which was quite a bit worse in the 1990s.

Amplifiers: what makes it more likely that we’ll see something worse than the late 1990s?

1. The global EM footprint, the US stride and a step in an uncertain direction in China: The size of EMs (and particularly China) is an incontrovertible difference from the 1990s, which implies a larger spillover to DM economies (Exhibit 2). What hasn’t changed – and amplifies the potential EM impact on DM – is that EM economies are still price takers

when it comes to global real interest rates. US growth sets the tone for global interest rates, which acts as an exogenous

2 see Is Global Growth Becoming More of a Zero Sum Game?

September 18, 2013

tightening of monetary policy for EM at exactly the wrong time. Should the downside risks we see to China’s growth materialize, it will be unambiguously negative for most EM economies.

2. Destabilizing factors also exist in EM: EM economies are certainly more resilient than they were in the 1990s, but they are by no means robust. The three key sources of instability in EM are:

i. Funding: The ‘Double Deficit Club’ needs to fund both its external and fiscal deficits at a time when funding costs are rising and capital is more reluctant to flow into EM.

ii. FX mismatch on foreign investors’ balance sheets: External vulnerability from high external debt (the ‘original sin’) has been replaced by foreign ownership in the domestic bond market, and risks of sovereign default have been replaced

Exhibit 2

The global EM footprint has increased significantly GDP Share of Global (PPP)

37%

63%

50% 50%

EM DM1997-98 2013 GDP Share of Global (current US$)

20%

80%

38%

62%

EM DM1997-98 2013 Source: Haver Analytics, Morgan Stanley Research

http://researchportal.ms.com/eqr/research/docs/content/ui/main.html#panel=search;s=Global%20Macro%20Analyst:%20Is%20Global%20Growth%20Becoming%20More%20of%20a%20Zero%20Sum%20Game?;ln=en;mode=best;dr=7:02/27/2013:02/27/2014

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by risks of defaults in the corporate sector. Thanks to a large increase in the foreign ownership of local bonds issued by corporates, a currency mismatch still exists for global investors in EM markets.

iii. FX reserves have improved dramatically only in select economies. In most others, import cover ratios are still the same or even worse than they were in the 1990s, because the size of their economies is bigger too (Exhibit 20). China, Russia and Brazil are the notable exceptions here. In times of stress, investors take selling of FX reserves as a bad sign, usually disregarding the higher stock of reserves in exposed economies3.

3. DM resilience should not be overstated either: The starting point for DM growth is weaker, and DM exposure to EM is higher, as we explain below. That makes DM economies vulnerable should an EM shock materialise.

What could cause an EM Shock?

An EM shock could occur either as a ‘sudden stop’ in one of the more exposed EM economies or it could originate as a sharp slowdown in growth in China. Regardless of where it starts, it is likely to spread.

A Sudden Stop in one of the ‘Double Deficit Club’ economies would spread quickly throughout EM

The ‘Double Deficit Club’ (Brazil, Turkey, South Africa, India, Indonesia – with Russia and Thailand applying for membership) has seen some recent divergence, but the club still remains exposed to the risk of a sudden stop.

A sudden stop requires all three ingredients: (i) a common creditor, (ii) a trigger, and (iii) vulnerable domestic fundamentals. But what is the fundamental vulnerability that makes for a sudden stop? Any one of these three can be the basis of domestic vulnerability: (i) a currency misalignment or a severe FX mismatch, (ii) an over-extended public sector balance sheet, or (iii) an over-extended private sector balance. Regardless of which one is the source of vulnerability, it usually spreads to the other two.

In the late 1990s, it was the public sector balance sheet that had committed the ‘original sin’ and issued a large amount of external debt. With currency pressures came the increasing ‘unsustainability’ of paying off that debt. Rising US interest

3 see GEMomentum: FX Reserves – Sign of Strength or Weakness?

September 16, 2013

rates and a stronger US dollar provided the triggers at a time when productivity had already been falling.

Today, the currency link comes via the rapid increase in foreign ownership we have seen in domestic bond markets, with issuance coming from the private sector even as productivity of investment was being questioned. The trigger could be the same: US rates and the US dollar, or it could be a sharp slowdown in China or a domestic event in any of the Double Deficit economies.4

A China Shock could cause even greater EM fallout

China has been a major growth engine for emerging economies in recent years. Its domestic demand has been persistently strong, supporting demand for manufactured goods as well as commodity prices (see Exhibit 3). As a result, China’s share in global emerging economies’ trade has risen to around 27%, up from 12.4% in 1996 and just 4% in 1980. China now accounts for 40-60% of the consumption of key global commodities, from copper to coal. Any major slowdown in China’s growth would therefore have significant direct and indirect effects on the growth outlook for the world’s other emerging markets.

The shock to regional, EM and global trade could be aggravated if there are supply chain and trade finance disruptions that accompany the shock to China’s growth.

A China shock would spill over to almost every economy in EM.

Exporters of manufactured goods to China would see volumes fall, but these economies are typically commodity importers and so would receive some (but not enough) offset from falling commodity prices. Most exposed: Korea, Taiwan, Thailand.

Commodity exporters, however, would face both falling volumes and worsening terms of trade. Most exposed: Latin America (ex Mexico), Indonesia, Malaysia, South Africa, Russia.

The financial channel would have a dual impact on EM, through a higher risk premium and funding concerns. Most

4 We have written extensively on these issues, so we direct interested

readers to our other notes: (i) Emerging Markets: What if the Tide Goes Out, June 14, 2013 (ii) Rise in Real Rates: Why it feels like the 1990s,

August 23, 2013(iii) The Global Macro Analyst: SuddEM Stop?

January 29, 2014

https://ny.matrix.ms.com/eqr/article/webapp/49f0c258-1ee8-11e3-ac00-dc711153eb1b?ch=rpint

https://ny.matrix.ms.com/eqr/article/webapp/c94794ca-b439-411f-ab7f-ea6cc7e34409?ch=rpint


https://ny.matrix.ms.com/eqr/article/webapp/11eb7326-0bb5-11e3-b059-9f82fc7a83a7?ch=rpint

https://ny.matrix.ms.com/eqr/article/webapp/d0c311d2-8914-11e3-ac8d-0f68393f74dc?ch=rpint

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exposed: Brazil, Turkey, South Africa and to a lesser extent India and Indonesia.

Given the dramatic growth in China’s credit market, a shock to China’s growth and in turn to its credit markets could well cause a de-rating of EM credit markets in general. Most exposed: Brazil, Turkey, India and to a lesser extent Indonesia5.

Non-fundamental and behavioural links can spread contagion too, sometimes to countries without fundamental weaknesses

Many countries subject to contagion in the late 1990s, and especially countries with relatively strong fiscal and current account balances, argued that the spread of contagion to their economies was unwarranted given their strong economic fundamentals – Classens and Forbes, 2004.

Exhibit 3

EM exposure to China

China Exposure

Exports to China + Hong

Kong % GDP

Exports to China + Hong

Kong % total exports

Net Exports of Fuel

(% GDP)

Net Exports of Ores/Metals

(% GDP)

2012 2012 2012 2012

AXJ

IND 2% 9% -8% -1%

KOR 17% 30% -11% -3%

TWN 29% 41% -11% -2%

IDN 3% 13% 2% 1%

MAL 14% 17% 6% -2%

THL 12% 17% -10% -2%

CEEMEA

RUS 2% 6% 18% 1%

POL 1% 1% -4% 0%

CZE 1% 1% -4% -1%

HUN 1% 1% -6% -1%

TUR 1% 2% -2% -2%

ISR 4% 12% -6% 0%

SAF 4% 13% -4% 7%

LatAm

BRA 2% 18% -1% 1%

MEX 1% 2% 2% 0%

CHL 8% 24% -6% 17%

PER 5% 20% 0% 13%

COL 1% 6% 11% 0%Source: Haver Analytics, Morgan Stanley Research

5 see EM Corporates: Rising Risk, Rising Leverage, 18 November,

2013.

It is nearly impossible to predict where ContagEM will spread without fundamental links, but it does imply that the effects could be more severe and affect more economies than just looking at fundamentals would suggest.

Calibrating the EM Shock

A ContagEM scenario would feed through to developed markets via three main triggers: imports, tighter financial conditions and lower commodity prices.

The shock to EM imports We assume that EM imports fall 15% over two quarters before starting to grow again. While we freely admit an arbitrary element to this calibration, we are guided by history and the results of a well-formulated study from the IMF6. Three points are worth considering.

First, during the Asian crisis, imports fell more than 40% in a quarter in some cases and by more than 20% in YoY terms. Our assumption of a 15% fall over two quarters with a recovery would mean that the YoY number would be substantially smaller. In the 1990s, robust DM growth helped EM exports to rebound relatively quickly. This time around, we don’t believe the starting point for DM economies is strong enough to drive such a rapid recovery.

Second, there is an element of non-linearity involved here. A widespread EM shock can create real volatility exceeding that suggested by fundamental links. Supply chain and trade finance disruptions have shocked trade before too.

Third, some further insights into the behaviour of trade in response to growth shocks comes from the Bems, Johnson and Yi (IMF, 2010) study. They argue:

Imports fall by a multiple of the decline in domestic demand. In the US, the 4.4% fall in domestic demand in 2008-09 was dwarfed by the 11.4% decline in imports.

Durable imports likely fall by even more. The fall in the demand for durables (32%) exceeded the fall in demand for non-durables and services (4%) by a factor of 8 in the US in 2008-09. Combined with the first point, a decline in domestic demand can create an extremely large decline in the demand for imports of durable goods.

6 Bems, Johnson, and Yi, 2010, “Demand Spillovers and the Collapse

of Trade in the Global Recession”, IMF Economic Review

https://ny.matrix.ms.com/eqr/article/webapp/ff24e946-5076-11e3-8d88-e0b4a3b58759?ch=rpint

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More open economies face a greater decline in trade. The elasticity of trade with respect to changes in demand is higher for other countries than for the US, in part because these economies are more open.

World trade can decline more rapidly during a crisis: The elasticity of trade to world GDP was 4 during 2008-09, higher than the 2.8 that the authors’ framework generates.

Put together, we argue that a 15% shock to EM imports is a reasonable projection in an EM shock scenario.

Our assumption of tighter financial conditions resembling those of the late 1990s is purely for comparability. Given that the size of a prospective shock is extremely hard to calibrate, and our objective is to generate a comparison with the late 1990s, an exogenous increase in volatility and tighter financial conditions similar to that period was an obvious choice.

Our assumption of lower oil prices comes from our strategists. The effect of weaker EM demand, supply responses and inventory assessment together deliver a profile for oil prices that suggests a dip below US$80/bbl for Brent before a gradual recovery commences (see page 68).

Why DM are more exposed this time around

In the scenario of an EM shock that involves most of EM, it is surprisingly easy to argue that there will be a stronger and more sustained impact on DM this time around, because of two main differences between now and the late 1990s: 1) a weaker starting point today, and 2) much bigger exposure to EM economies through exports, corporate revenues and banks. For the US, euro area and Japan, there is a lot of differentiation with respect to the impact of an EM shock. For Australia and New Zealand, the commodity links are more obvious, but some interesting divergences appear there too.

A weaker starting point

The starting point for the US and particularly the euro area economies is worse now than it was in the late 1990s, and the room for policy manoeuvre is more limited too. Japan’s starting point is more mixed.

The growth trajectory is much weaker in both the US and particularly for the euro area relative to the late 1990s (Exhibit 5). Both economies are thus more vulnerable than they were to a negative shock to growth – the US given spectacular domestic demand-led growth in the late 1990s, and the euro area given very poor domestic demand now. Japan does have

a slightly weaker starting point now than in the late 1990s, but is on a better prospective growth trajectory. Back then, a consumption tax helped push the economy back into recession, but ‘Abenomics’ and a responsive BoJ today still hold promise for Japan’s future.

A related risk is that of deflation. The euro area in particular and the US to a lesser extent are already dealing with a disinflationary risk, while Japan is actually moving quite successfully in the other direction. A deflationary EM shock would likely affect sentiment surrounding the euro area the most, but could raise questions about deflationary risks in the other two economies as well.

The contribution of domestic demand and net exports to growth is also different in the three major DM economies (Exhibits 24-28). Again, it is the euro area that stands apart. Domestic demand is still a drag on growth, and it is net exports that are propping up what little growth the euro area is seeing. The contrast with the late 1990s, when the domestic demand contribution was strong, is striking. In the US, the situation is far more balanced, with both domestic demand and net exports contributing positively to growth. The 1990s, though, were all about domestic demand rather than exports, which exposes US growth to an export shock just that little bit more this time around. In contrast to the euro area and the US, Japan’s mix of domestic demand and net export contribution is not very different from the 1990s, and domestic demand is playing a steady role in Japan’s growth story.

What about monetary policy legroom? Monetary policy is least constrained and we think most likely to respond quickly to an EM shock in the US (where the Fed is already voicing concern about this issue) and Japan (where the BoJ is unlikely to submit to deflationary pressures after winning the hard-fought uptrend in inflation).

Real and financial links to EMs are stronger today

1. Exposure via exports Exhibits 30 and 33 tell us that around 21% of the euro area’s exports, 43% of US exports, and 59% of Japan’s exports go to EM7. However, when those exports to EM are weighed as a percentage of GDP, the ranking changes so that it is the euro area and Japan whose exports to EM are largest. The export channel is thus relatively less important in the US. Given exports are a sizeable conduit, how much DM growth will suffer clearly depends on how sharply EM imports fall.

7 We define EM as the set of countries covered by Morgan Stanley EM

economists. The full list is given below Exhibit 30.

11



2. Exposure via corporate revenues EM accounts for a large share of corporate revenues in the euro area (32%) and for corporates listed in the S&P 500 (25%). Our equity strategy team points out that 65-80% of European corporate revenue growth in recent years has come from EM, thanks in no small part to poor demand at home. In the US, however, EM exposure has been falling on a relative basis thanks to a better domestic demand profile. Japan Inc.’s exposure to EM from corporate revenues is smaller, at 12%.

Not all sectors in these markets are equally exposed to EM for their sales. There is some offset. Given that the commodity and energy reliance of all these economies is different, some offsetting effects from lower energy and commodity prices will help the corporate sector.

3. Exposure via banks Eurozone banks’ relative exposure to EM (measured by EM claims to domestic GDP) has grown significantly since the late 1990s, and this increased exposure represents a channel of ContagEM to the eurozone economy and markets. Austrian, Greek and Portuguese banks are much more exposed than they were back then (see Exhibit 4) – though part of the increase in Austrian bank exposure is the result of M&A activity. Spain, on the other hand, is no more exposed than it was, while French banks have increased their exposure, but recent retrenchment as a result of regulation and funding squeezes has slowed the growth in exposures, especially in CEE and Asia.

However, there are a number of offsetting factors to consider. First, the positive side of what our Banks team has called “the Balkanisation of banking markets” is that subsidiaries with ringfenced capital and funding in emerging markets reduce the intensity of the transmission mechanism of bank stress to and from a subsidiary. The vast majority of subsidiaries of European banks in Latin America and Asia are set up like this.

Second, European banks are a long way through deleveraging – although by no means finished. Eurozone banks have shrunk their holdings of cross-border claims by 40% or US$8tn in the last four years to US$10tn. This splits roughly as half cross-border in the eurozone, a quarter claims on the US and quarter claims on emerging markets, Asia and the rest of the world. As a result, we think the transmission mechanism for wholesale/ cross-border banking is weaker than in 1997 for Asia.

4. Exposure via recent global diversified portfolio investments Over the past five years, pension funds, sovereign wealth funds and their peers – which we label ‘global diversified

Exhibit 4

The banking channel for DM exposure to EM

Banking system claims on EM, % GDP

0%

15%

30%

45%

60%

75%

US

Aus

tral

ian

Can

adi

an

Jap

anes

e

Ger

ma

n

Ital

ian

Sw

edi

sh

Por

tugu

ese

Fre

nch

Sw

iss

Eu

rop

ean

Gre

ek

UK

Spa

nish

Au

stria

n

1997-Q4 2003-Q4 2013-Q3

Banking system claims on EM, % Capital and reserves

0%

40%

80%

120%

160%

200%

Ital

ian

Po

rtu

gu

ese

Ger

man

Fre

nch

Sp

an

ish

Gre

ek

Aus

tria

n

1997-Q4 2003-Q4 2013-Q3

Source: Haver Analytics, Morgan Stanley Research

portfolios’ – have acted to remedy the under-allocation to EM assets in their portfolios. We estimate the average allocation to EM in DM cross-border portfolios is around 10%8. EM asset markets now represent nearly 20% of the universe of equity and fixed income – three times the EM share in 2000. EM market dislocations therefore have a direct link to DM portfolios, suggesting that risk aversion could be transmitted rather directly from EM markets to DM investors.

Further Down Under

Australia and New Zealand are among the most exposed DM economies when it comes to exports to EM (see Exhibits 30 and 33), and both have benefitted disproportionately during the so-called ‘commodity super cycle’. As a result, the impact on export volumes as well as the terms of trade deterioration would hurt both economies. Australia’s direct links with China and EM, and New Zealand's direct (from China/EM) as well as indirect links via weaker growth in Australia (New Zealand's biggest trading partner) would come into play.

8 see EM Profile: Small Fish in a Big Pond May 2, 2012).

https://ny.matrix.ms.com/eqr/article/webapp/c9ed9045-e6cd-47d7-b8f5-614b58f511d9?ch=rpint

12



What would an EM shock do to growth and markets?

We consider the first-round effects of an EM shock on growth, markets, and asset allocation and cross-asset considerations.

1. The impact on growth

US growth: The average quarterly annualised drag on US growth in the first four quarters after the shock is 1.4 percentage points, in our scenario. The shock to exports and to financial conditions is offset by the policy reaction from the Fed and by lower commodity prices. Only the relative robustness of US growth keeps the impact of this growth shock from being more severe.

Euro area growth: The euro area faces the risk of a recession with consecutive quarters of negative growth. The drag on growth is sharp, but FX weakness and lower bond yields provide an offset that helps push growth higher in 2015. In the wake of the shock, deflation risks that already exist could be aggravated

Japan growth: Japan, like the euro area, could face a recession, with consecutive quarters of negative growth and a drag on growth that extends into 2015. EM accounts for 60% of Japan’s exports (China alone accounts for 23%) which makes the export channel more important than in the US and the euro area. A policy response from the BoJ as well as lower commodity prices would help, but a growth shock from EM would make escaping deflation much harder.

Australia and New Zealand growth: Australia would experience a substantial drag on growth, with a 1.8pp average quarterly drag on growth in the four quarters after the shock, in our scenario. The Australian economy would likely flirt with recession, and only the RBA’s prompt action would keep growth north of zero for a couple of quarters. New Zealand would be hit by both lower EM growth and lower growth in Australia (New Zealand’s biggest trading partner). As a result, growth in New Zealand could face a drag of around 2% in 2014 too.

For more detail on these scenarios, see the Economics section starting on page 24.

Exhibit 5

The drag on growth from ContagEM ContagEM Drag on DM Growth

-4

-3

-2

-1

0

1

2

1 2 3 4 5 6 7 8

US Euro Area Japan Australia

% points, qoq saar

Source: Morgan Stanley Research

2. The impact on markets

Equity markets European equity markets are likely to be more adversely affected than the US and Japan. Within EM, the equity markets in ASEAN, China, Chile and Poland are most dependent on growth in other EM economies. Differentiation will exist not just among markets but among sectors in each market too. In Europe, energy, metals, technology and staples have the highest exposure to EM. In the US, it turns out to be technology, energy, materials and industrials that are most exposed. Japan’s most exposed sectors are materials, consumer discretionary, technology, energy and industrial sectors.

EM equity markets are naturally more exposed to EM than the euro area, the US or Japan. More than 90% of revenues derive from EM for the corporate sector in Indonesia, Thailand and Malaysia, with the next highest exposure among corporates in China, Chile, Brazil and Poland. For Singapore, Taiwan and Russia, less than 60% of the revenues of listed equities come from EM.

Our equity strategy team has screened for stocks with the highest EM exposure in the US, Europe and Japan (see pages 51 to 56).

13



FX markets In the DM FX space, the deflationary shock from an EM shock would likely push the USD and JPY higher. After an initial move in USDJPY to 90, we think that the BoJ would respond, so that USDJPY would not remain offered for long. EURUSD, on the other hand, could decline down to 1.18 in a ContagEM scenario.

EM currencies could face more headwinds than they already do, but we note that they have been adjusting for a while now. The sharp appreciation of real effective exchange rates (REERs) prior to the 1997-98 and 2007-08 declines led to a large REER adjustment in the other direction, but such appreciation was in place prior to May 2012, not today. We worry in particular about the ruble, given the scope for fundamental deterioration and lower oil prices.

Rates markets In a ContagEM scenario, government bond yields in the G4 markets (US, Germany, UK, and Japan) could fall dramatically – similar to how they reacted during the various flight-to-quality episodes in 2008 through 2011. In a world where the return of capital is paramount to the return on capital, the G4 government bond markets offer the safest haven – with perhaps the exception of gold.

EM rates in a ContagEM scenario, on the other hand, are likely to be driven by risk premia in the ‘Double Deficit Club’ (Brazil, Turkey, South Africa, to a lesser extent India, Indonesia, and also new ‘applicants’ Russia and Thailand). The ongoing adjustment of real rates in these economies is likely to accelerate. That may eventually give way to stabilization, but for now, and certainly in a ContagEM scenario, EM local rates will remain under pressure.

Credit markets In both the US and Europe, credit markets are likely to be less exposed to EM than equity markets, given the skew in issuance from more domestically oriented names. In the US, EM credits and sectors with high EM exposure would likely suffer over a longer horizon, though more liquid parts of the market like the CDX indices and Financials credits would experience weakness in the near term. Lower net supply and ‘safe haven’ flows could mitigate the impact. In Europe, the energy, materials, autos and chemicals are highly exposed to EM, with select single name stocks in mining and autos showing high exposure to large EMs

EM credit markets are dominated by China’s issuance surge, and market action in China is likely to set the tone for EM credit markets. China risk adds another source of uncertainty to the already challenged EM credit space. We believe that

EM sovereign credit would also be affected through the indirect route of illiquidity and worsening corporate credit.

Commodities markets An EM shock in 2Q14 could join forces with poor seasonal demand to drag oil prices below US$80 before a recovery, with oil averaging US$95/bbl for 2014. EM growth has driven the overwhelming majority of demand growth for oil, so a growth shock to EM would produce a sharp reduction in prices, with only a supply response keeping prices from falling further.

An EM shock and over-supply would likely combine to push iron ore and copper prices lower. Gold, though, would probably benefit from safe-haven seeking investors and could return to its 2013 average, and possibly even higher.

3. Asset allocation implications

Could the EM shock actually lead to a counter-intuitive preference for EM over DM? If the EM shock we assume materializes, economic conditions in EM will lead to a sizeable underperformance relative to DM markets in the early stages of ContagEM. Yet, if that underperformance goes far enough, the fall in asset prices may be enough to drive the macroeconomic adjustment. Or policymakers may commit to a pipeline of structural reforms. From a macroeconomic standpoint, we would like to see productive investment from more sustainable sources of growth take over as the driver of growth from current unsustainable ones. The fall in asset prices could also drive valuations and sentiment to extreme levels. The combination of a better macro picture and attractive sentiment and valuation levels could be the catalyst for medium-term outperformance of EM over DM.

Cross-asset implications. Our strategists suggest the following: Bonds would most likely outperform everything else, with

the possible exception of gold.

Hard commodities, oil, and EM and European equities would likely be the worst performing in this scenario.

EU equity market and FX weakness present a worrisome combination. USD strength – partly reflecting the resilience of the US economy and the relatively lower EM exposure of US equities – would help support risk sentiment in the US.

For more detail on the investment implications, see the Strategy section starting on page 41.

14



ContagEM Chartbook

15



The risk of a sharp China slowdownExhibit 6

Growth has fallen and rates have risen

8.5%

7.8%

-3

2

7

12

17

De

c-0

3

De

c-0

4

De

c-0

5

De

c-0

6

De

c-0

7

De

c-0

8

De

c-0

9

De

c-1

0

De

c-1

1

De

c-1

2

De

c-1

3

Real Lending Rate, %p.a.Real Weighted Lending Rate, % p.a.Real GDP Growth of Secondary Industry, YoY%

7.4%

China

Source: Source: CEIC, Morgan Stanley Research

Exhibit 7

Consumption needs to be a bigger driver of growth

35%

37%

39%

41%

43%

45%

47%

49%

200

0

200

1

200

2

200

3

200

4

200

5

200

6

200

7

200

8

200

9

201

0

201

1

201

2

201

3

7.5%

8.5%

9.5%

10.5%

11.5%

12.5%

13.5%

14.5%2012: 48.1%

Investment (% of GDP), LS

2013:7.7%

Real GDP Growth (YoY %), RS

Source: CEIC, Morgan Stanley Research

Exhibit 8

Medium/Large corporates have levered up

20.8% 21.6% 20.6% 18.9% 18.6% 19.4%

15.8% 25.0% 25.3% 24.5% 25.9% 28.4%

71.9%79.5% 80.0% 82.6%

99.0%105.9%

34.9%

40.1% 53.3% 53.1%

57.7%62.1%

11.9%

16.2%18.7% 18.8%

20.1%22.7%

155.3%

182.5%197.9% 197.8%

221.3%238.5%

2008 2009 2010 2011 2012 2013Central Government Local Government Mid/large Corporate Small Business Household

China Debt to GDP Ratio, %


Exhibit 9

PPI deflation implies higher real borrowing costs

-9

-7

-5

-3

-1

1

3

5

7

9

11

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

China PPI Inflation, YoY%

PPI has remained in deflation in past 23 months


Exhibit 10

A rising ICOR suggests falling productivity

2.8

3.3

3.8

4.3

4.8

5.3

5.8

6.3

200

3

200

4

200

5

200

6

200

7

201

0

201

1

201

2

201

3

201

4E

3Y, Trailing Avg

Annual

China Incremental Capital Output R ti

Weaker Capital Productivity


Exhibit 11

Challenging demographics

35%

45%

55%

65%

75%

19

50

19

60

19

70

19

80

19

90

20

00

20

10

20

20

E

20

30

E

20

40

E

20

50

E

-1.5%

-0.5%

0.5%

1.5%

2.5%

Additions to Working Age Population (5Y Avg Growth)-RS

Age Dependency Ratio (%)-LS

China Projected

2011-15

Source: UN Population Database, 2012 Revision, E=UN estimates, Morgan Stanley Research

16



China’s impact on trade and credit markets Exhibit 12

China stepped up to provide a source of end demand as DM domestic demand weakened

-5%

-3%

-1%

1%

3%

5%

7%

9%

11%

13%

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

China US EU27 Japan

Domestic Demand, Real Annual Growth, %

Source: CEIC, MS Research

Exhibit 13

China’s share of EM and Global Trade has risen

15%

20%

25%

30%

35%

40%

45%

Jan

-90

Apr

-91

Jul-9

2O

ct-9

3Ja

n-9

5A

pr-9

6Ju

l-97

Oct

-98

Jan

-00

Apr

-01

Jul-0

2O

ct-0

3Ja

n-0

5A

pr-0

6Ju

l-07

Oct

-08

Jan

-10

Apr

-11

Jul-1

2

8%

13%

18%

23%

28%

33%

EM's Share in Global Trade, LS

China's Share in EM Trade, RS

%, 12M Trailing Sum

Source: Haver Analytics, IMF, Morgan Stanley Research

Exhibit 14

China's % Contribution to World Demand Increase

64

98

5953

106111

2012Copper Iron Ore Aluminium Steel Oil Coal

Source: Morgan Stanley Research

Exhibit 15

China corporates have been among the most active issuers of external corporate bonds

-100

-50

0

50

100

150

200

Indi

a

Bra

zil

Chi

na

Tur

key

Rus

sia

Indo

nesi

a

Chi

le

Col

ombi

a

Mex

ico

Per

u

Ukr

aine

S A

fric

a

Kaz

USDbn Other Ext Debt

Global Bonds

Net Change in External Debt (4Q08 - 3Q13)

Source: BIS, Morgan Stanley Research, *Estimate for China

Exhibit 16

Brazil, China and Russia are the dominant issuers of external corporate bonds

Brazil20%

Russia14%

China12%

Hong Kong7%

Mexico7%

India5%

Korea5%

Turkey3%

Rest of EM27%

Source: Bloomberg, Bond Radar, Morgan Stanley Research

Exhibit 17

China now dominates the Asian dollar bond market

China , 28%

Indonesia , 12%

India , 9%

Philippines , 8%

Singapore , 6%

Malaysia , 3%

South Korea, 16%

Hong Kong , 12%

Thailand , 3%Rest of Asia,

3%

Source: Bloomberg Morgan Stanley Research

17



The ‘Double Deficit Club’ and EM vulnerabilities Exhibit 18

Double deficit club had more members in 1997

CHN

IND KOR

IDN

MAL

THL

TWN

BRA

MEX

CHL

PER COL

RUS

POL

CZE

HUN

TUR

ISR

SAF

UKR

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

-10% -8% -6% -4% -2% 0% 2% 4%

Budget Balance (% of GDP)

CAB (% of GDP)

Source: Haver Analytics, Budget Balance 2014 forecasts are IMF's, CAB forecasts are Morgan Stanley Research

Exhibit 19

Fiscal positions are weaker today despite the improvement in macro fundamentals

General Gov't Debt (% of GDP): 1997 and Today

CHL RUS PER IDN

CHN

COL

KOR TUR

TWN PHI SAF

MEX

THL

CZE ARG

MAL

POL

IND BRA ISR

HUN

0%

20%

40%

60%

80%

100%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

1997

2014e

Fiscal position has improved since 1997

Fiscal position weaker now than in 1997

Source: International Monetary Fund, Morgan Stanley Research

Exhibit 20

Import cover is near 1990s’ level in many economies

Import Cover: 1997 and Today

0

5

10

15

20

25

30

CZ

E

ME

X

SA

F

HU

N

CH

L

IDN

PO

L

TU

R

MA

L

IND

KO

R

CO

L

TH

L

ISR

BR

A

PE

R

RU

S

CH

N

Latest Q

1997

FXR/monthly imports


Exhibit 21

Fewer are in the ‘double deficit club’ today, but funding needs are still high

The Double Deficit Club Today

CHN

IND

KOR

IDN

MAL

THL

BRA

MEX

CHL PER

COL

RUS

POL

CZE

HUN

TUR

ISR

SAF

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

-10% -8% -6% -4% -2% 0% 2% 4%

Budget Balance (% of GDP)

CAB (% of GDP)

Source: Haver Analytics, Budget Balance 2014 IMF, CAB forecasts Morgan Stanley Research

Exhibit 22

Current accounts are in deficit for most but are less stretched than in the past

CAB (% of GDP): 1997 and Today

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

UK

R

SA

F

TU

R

CH

L

PE

R

CO

L

BR

A

CZ

E

ISR

PO

L

IDN

ME

X

IND

AR

G

RU

S

CH

N

HU

N

TH

L

MA

L

KO

R

TW

N

Latest (4Q rb)

1997

UKR= -12%

TWN= 13%


Exhibit 23

Foreign ownership of local bonds is significantly higher than before Lehman collapse

Foreign Ownership of Local Bonds (Bil. US$)

0

20

40

60

80

100

120

140

PER CZE THL HUN IDN SAF MAL KOR TUR POL MEX BRA

Latest pre-Lehman

Source: National sources, Haver Analytics, Morgan Stanley Research

18



DM starting points are much weaker for the euro area, weaker for the US, but mixed for Japan Exhibit 24

US growth is lower now than it was US GDP Q%, 2y MA

0

0.002

0.004

0.006

0.008

0.01

0.012

0.014

T-8

T-7

T-6

T-5

T-4

T-3

T-2

T-1 T

T+

1

T+

2

T+

3

T+

4

T+

5

T+

6

T+

7

T+

8

T=1997Q1

T=2013Q4


Exhibit 25

Euro area growth is significantly weaker Euro area GDP Q%, 2y MA

-0.004

-0.002

0

0.002

0.004

0.006

0.008

T-8

T-7

T-6

T-5

T-4

T-3

T-2

T-1 T

T+

1

T+

2

T+

3

T+

4

T+

5

T+

6

T+

7

T+

8

T=1997Q1 T=2013Q4


Exhibit 26

Prospective growth in Japan is better Japan GDP Q%, 2y MA

-0.006

-0.004

-0.002

0

0.002

0.004

0.006

0.008

0.01

T-8

T-7

T-6

T-5

T-4

T-3

T-2

T-1 T

T+

1

T+

2

T+

3

T+

4

T+

5

T+

6

T+

7

T+

8

T=1997Q1 T=2013Q4


Exhibit 27

US domestic demand is contributing less US GDP Contributions, Y% 2y MA

-0.02

0

0.02

0.04

0.06

T-8

T-7

T-6

T-5

T-4

T-3

T-2

T-1 T

T+

1

T+

2

T+

3

T+

4

T+

5

T+

6

T+

7

T+

8

Domestic Demand (T=1997Q1) Domestic Demand (T=2013Q4)

Net Exports (T=1997Q1) Net Exports (T=2013Q4)

Source: Company Data, Morgan Stanley Research

Exhibit 28

Euro area domestic demand is a drag on growth Euro area GDP Contributions, Y% 2y MA

-0.02

0

0.02

0.04

T-8

T-7

T-6

T-5

T-4

T-3

T-2

T-1 T

T+

1

T+

2

T+

3

T+

4

T+

5

T+

6

T+

7

T+

8

Domestic Demand (T=1997Q1)

Domestic Demand (T=2013Q4)

Net Exports (T=1997Q1)

Net Exports (T=2013Q4)


Exhibit 29

Japan domestic demand contribution isn’t as strong Japan GDP Contributions, Y% 2Y MA

-2.00%

0.00%

2.00%

4.00%

T-8

T-7

T-6

T-5

T-4

T-3

T-2

T-1 T

T+

1

T+

2

T+

3

T+

4

T+

5

T+

6

T+

7

T+

8

Domestic Demand (T=1997Q1) Domestic Demand (T=2013Q4)

Net Exports (T=1997Q1) Net Exports (T=2013Q4)


19



ContagEM – the export and corporate revenue channels Exhibit 30

Exports to EM important in euro area and Japan Exports to EM (% of GDP)

0%

2%

4%

6%

8%

10%

US EA JPN NZ AUS

2012 1997

Note: EM includes CHN, IND, KOR, TWN, HKG, SIN, IDN, MAL, THL, RUS, POL, HUN, CZE, TUR, ISR, SAF, BRZ, MEX, CHL, PER, COL. Source: Haver Analytics, Morgan Stanley Research

Exhibit 31

US exposure could range between 18% and 24% S&P500, % of total revenue by region

24.5

67.8

7.7

EM

Domestic

DM ex domestic

Source: Company Data (2013), Morgan Stanley Research

Exhibit 32

Japan’s exposure to EM is limited Japan, % of total revenue by region

13.8

76.2

76

EMDomesticDM ex domestic


Exhibit 33

Most of Japan’s exports go to EM Exports to EM (% of total exports)

0%

10%

20%

30%

40%

50%

60%

EA NZ US JPN AUS

2012 1997


Exhibit 34

Europe has the highest exposure to EM Europe ex UK, % of total revenue by region

31.9

30.5

37.6

EM

Domestic

DM ex domestic


Exhibit 35

EM corporates exposure to EM is high but varies EM, % of total revenue by region

76

24

EM DM


20



Global Equity Strategy – Europe relatively more exposedExhibit 36

European companies’ exposure to EM has nearly tripled in 15 years

8

12

16

20

24

28

32

1997 1999 2001 2003 2005 2007 2009 2011 2013

Eur

ope

ann

Co

mpa

nie

s -

% o

f T

ota

l Re

venu

es

fro

m E

M

Note: Emerging markets are defined here as World ex developed Europe, North America, Japan and Australasia. Data refer to our analysts’ 2013 estimates as at May 2013, based on company information in combination with their estimates where disclosure is not detailed enough. Source: Morgan Stanley Research

Exhibit 37

The proportion of revenue growth coming from EM has fallen materially for US companies

-20%

0%

20%

40%

60%

80%

100%

2009 2010 2011 2012

US

sto

cks

- %

con

trib

utio

n to

rev

enue

gro

wth

fro

m E

M

EM Europe US

Source: Company data, Morgan Stanley Research

Exhibit 38

EM/RoW has accounted for the majority of top-line growth for European companies in recent years

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2011 2012 2013 2014 2015

%pt

Con

trib

utio

n to

Rea

l Rev

enue

-Wei

ghte

d G

loba

l GD

P G

row

th (

%)

EM/RoW Europe US


Exhibit 39

In the US, Technology, Energy, Materials and Industrials have the greatest sales exposure to EM

% of Total Sales Asia +

Sector US Asia Europe Others Others

Information Technology 41.3% 19.0% 10.1% 29.5% 48.6%

Energy 55.3% 2.2% 7.1% 35.4% 37.7%

Materials 52.7% 9.1% 16.2% 22.0% 31.1%

Industrials 62.1% 10.5% 11.9% 15.5% 26.0%

Consumer Staples 69.8% 2.3% 4.7% 23.2% 25.5%

Consumer Discretionary 74.2% 3.6% 10.1% 12.0% 15.7%

Financials 81.8% 6.4% 5.3% 6.5% 12.9%

Health Care 79.9% 4.0% 7.8% 8.3% 12.3%

Utilities 93.6% 0.2% 1.1% 5.2% 5.3%

Telecommunication Services 100.0% 0.0% 0.0% 0.0% 0.0%

S&P 500 68.0% 6.0% 7.8% 18.2% 24.2%

Source: Bloomberg, Morgan Stanley Research

Exhibit 40

In Europe, Energy, Materials, Technology and Staples have the greatest sales exposure to EM

% of Total Sales from:

Developed Europe US Other EM

Energy 16.9 22.9 6.0 54.3

Materials 33.7 18.8 4.7 42.8

Information Technology 36.2 21.4 6.9 35.6

Consumer Staples 49.0 14.8 1.7 34.5

Consumer Discretionary 45.1 22.0 2.4 30.6

Industrials 49.0 17.5 4.2 29.3

Telecommunication Services 65.6 5.8 0.7 27.9

Health Care 35.3 33.3 5.3 26.1

Financials 61.8 15.8 2.3 20.1

Utilities 78.5 5.1 0.1 16.2

Europe 46.6 17.6 3.3 32.6


Exhibit 41

In Japan, Materials, Consumer Discretionary, Technology, Energy and Industrial sectors have the greatest exposure to EM

Sector AxJ (%)Europe

(%) North

America (%) Others

(%)Japan

(%)AxJ +

Others (%)

Materials 15.0 1.4 3.5 11.6 68.6 26.6

Consumer Disc. 12.4 5.5 16.2 9.6 56.4 21.9

Information Tech 17.0 9.2 10.0 4.5 59.3 21.5

Energy 6.8 0.2 0.9 4.7 87.5 11.5

Industrials 7.8 2.4 3.8 3.3 82.6 11.1

Consumer Staples 3.0 0.8 3.8 2.9 89.5 5.9

Health Care 2.8 4.8 9.4 1.8 81.2 4.6

Financials 0.4 0.2 0.1 0.4 98.9 0.9

Telecom 0.0 0.0 0.0 0.0 100.0 0.0

Utilities 0.0 0.0 0.0 0.0 100.0 0.0

Japan 9.0 3.3 7.1 5.3 75.2 14.3


21



FX and Rates Strategy – EUR exposed, DM bonds safe havens

Exhibit 42

US banks are increasing domestic lending

750

950

1150

1350

1550

1750

1950

2150

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

4000

4500

5000

5500

6000

6500

Loans to foreigners in USD

S

USD bn

USD bn


Exhibit 43

EU banks reduced foreign asset holdings more quickly than domestic holdings

10

12

14

16

18

20

22

24

26

28

30

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Tho

usan

ds

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

Tho

usan

ds

Domestic Assets External Assets (RHS)

EUR trn

EUR trn

Source: Reuters EcoWin, Morgan Stanley Research

Exhibit 44

Rates differentials suggest a much lower EURUSD

1.26

1.28

1.30

1.32

1.34

1.36

1.38

Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4

EUR/USD 1Y1Y Spread (RHS)


Exhibit 45

DM rates traded lower in tandem during crisis; US and German 2s10s steepened sharply in response to the LTCM bailout

-100

0

100

200

300

Jan-97

May-97

Sep-97

Jan-98

May-98

Sep-98

Jan-99

May-99

Sep-99

0.0

2.0

4.0

6.0

8.0

2s10s DE 2s10s US 2s10s JPY

10s DE (RHS) 10s US (RHS) 10s JPY (RHS)

bp %

Source: Thomson Reuters EcoWin, Bloomberg, Morgan Stanley Research

Exhibit 46

5y5y swaps

4

6

8

10

12

Jan-97

May-97

Sep-97

Jan-98

May-98

Sep-98

Jan-99

May-99

Sep-99

-25

25

75

125

175

225DE 5y5yIT 5y5yDKK 5y5ySEK 5y5yIT/DE 5y5y Spread (RHS)

% bp

Source: Thomson Reuters EcoWin, Morgan Stanley Research

Exhibit 47

Central bank policy response

2.0

3.0

4.0

5.0

6.0

Jan-97

May-97

Sep-97

Jan-98

May-98

Sep-98

Jan-99

May-99

Sep-99

0

100

200

300

400

500

600

DE US EM Equity Performance (RHS)

% Index Value


22



Commodities Strategy – At risk, but not 2008 reduxExhibit 48

Soft commodities and base metals most exposed to EM demand weakness; natural gas is purely DM (% of end market demand/consumption by region)

0%

20%

40%

60%

80%

100%

Nat

ura

l Gas

Co

coa

Pa

lladi

umC

offe

eR

BO

BP

latin

umS

ilver

Bre

ntH

eatin

g O

ilN

icke

l C

orn

Lea

n H

ogs

Zin

cC

oppe

rLi

ve C

attl

eF

eed

erL

ead

Alu

min

umW

hea

tS

uga

rS

oybe

ans

Gol

dC

otto

n

DM EM (ex China) China Source: Bloomberg, Morgan Stanley Commodity Research; Natural gas benchmarked to US

Exhibit 49

Brent could average <$95 in a ContagEM scenario (MS Brent average price forecast scenarios, US$/bbl)

98

106

103

98

106

85

89

96 96

108

1Q14 2Q14 3Q14 4Q14 2015Base ContagEM

Source: Morgan Stanley Commodity Research estimates

Exhibit 50

EM is the primary driver of oil demand growth (Global oil product demand growth, mmb/d)

1.3

1.0

0.4

0.9

1.2

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4 OECD Non-OECD Total

2014 2015

Base BaseContagE ContagE

2013 Source: IEA, Morgan Stanley Commodity Research estimates

Exhibit 51

Copper price vs costs: Example of a market vulnerable to significant downside

0

50

100

150

200

250

300

350

400

450

1999 2001 2003 2005 2007 2009 2011 2013

US

c/lb

0

2,000

4,000

6,000

8,000

10,000

US

$/t

LME Cash Copper Price50th Percentile60th Percentile70th Percentile80th Percentile90th Percentile

Source: Wood Mackenzie, Morgan Stanley Research

Exhibit 52

Iron Ore price vs costs: Example of a market less likely to overshoot

20

40

60

80

100

120

140

160

180

200

2006 2007 2008 2009 2010 2011 2012 2013 2014

US

$/t

cfr

Chi

na

20

40

60

80

100

120

140

160

180

200

US

$/t

cfr

Chi

na

50th Percentile 60th Percentile 70th Percentile

80th Percentile Spot Iron Ore , 62% fe CFR China 90th Percentile

90th Percentile Source: Wood Mackenzie, Morgan Stanley Research

Exhibit 53

Gold vs US 5-year tip yield: Linked to risk-aversion

$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

2007 2008 2009 2010 2011 2012 2013 2014

US

$/o

z

-2.5

-1.5

-0.5

0.5

1.5

2.5

3.5

5-ye

ar T

IPS

Yie

ld

Gold Price (LHS)

US 5-year TIP, yield %( S)

INVERTED SCALE


23



Economics

24



US: Domestic growth and policy reaction mitigate impact

Ellen Zentner, Ted Wieseman

An EM shock would produce an average quarterly annualised drag on US growth of 1.4 percentage points in the first four quarters after the shock, we estimate.

The shock to exports and to financial conditions would be offset by the policy reaction from the Fed and by lower commodity prices.

Only the relative robustness of US growth would keep the impact of our EM shock scenario from being more severe.

What happened in the late 1990s?

After a significant mid-cycle slowdown in 1995 and early 1996 that followed an aggressive 1994 rate normalization by the Fed, the US economy gathered pace through 1996 and the first half of 1997 (real GDP grew at 4.6% in 1H97, the unemployment rate fell to 5.0%), but headline PCE inflation rose only 1.4%, and core by 1.8% – a performance the Fed’s July 1997 Monetary Policy Report described as “exceptional.”

The FOMC adopted a tightening bias in July 1996 but hiked only once in March 1997 to 5.50%, because tight labor conditions did not pressure inflation thanks to rising productivity growth as the tech investment boom took hold. As the Asian crisis intensified in the second half of 1997, slowing US export growth was offset by strengthening domestic demand, a flight to safety helped drive the 10-year Treasury yield down 75 bp, slowing Asian demand depressed energy prices, and a surge in the dollar lowered US import prices. The Fed’s early 1998 Monetary Policy Report continued to describe the economy’s performance in 1997 as “exceptionally good.”

Still, in December 1997, the FOMC was sufficiently concerned about the risks from the crisis in Asia to drop its longstanding tightening bias. However, the effects of the Asian crisis on the US to that point were still described as having “been quite limited so far.” Indeed, the economy showed no signs of slowing in early 1998, as accelerating domestic demand supported by easier overall financial conditions and lower energy prices continued to offset sharply slowing exports.

Amid this strength, the Fed reinstated its tightening bias in March 1998, but low inflation kept it from following through, and the tightening bias was then dropped in August 1998 as the Asia crisis spread to Russia.

Fed Chairman Greenspan became increasingly worried that the spreading of the financial crisis from Asia would damage the until then highly resilient US economy. Following the emergence of the LTCM crisis, the FOMC cut rates 25 bp in September, October, and November, lowering the fed funds target to 4.75%. The 10-year Treasury yield fell 80 bp from the end of June to the end of December. Equities fell 19% between mid-July and the end of August, but quickly recovered, and oil prices continued plunging, sharply lowering US headline inflation and supporting real income growth.

Chairman Greenspan’s fears of a spillover to slower US growth were not realized, as US real GDP growth accelerated in the second half of 1998 to +6.0%, thanks to lower interest rates, energy prices, and resumed gains in stocks, which continued to drive strength in domestic demand. By May, Fed officials realized that the continued strength in the economy and recovery in financial markets “could imply the lower federal funds rate established last fall was no longer entirely appropriate.” The economy continued booming in 1999, growing 4.9% Q4/Q4, the unemployment rate fell to 4.0%, the tech stock bubble sharply accelerated, the 10-year Treasury yield backed up 200 bp, reversing the drop from mid-1997 to the end of 1998, and soon the FOMC was scrambling to catch up and reverse the late 1998 cuts, hiking rates from June 1999 to May 2000 by 175 bp to 6.50%. A mild recession followed in 2001 after the tech bubble popped.

The key takeaway from the experience of the late 1990s was the greater role of overall financial conditions in transmitting – or mitigating – global financial market strains to the US over direct export channels.

The US is a relatively closed economy, but its financial linkages to the rest of the world are much larger. The sharp drop seen in interest rates in 1997-98, the ultimate resilience in risk markets after some bouts of substantial weakness, and the support for domestic real income growth from the decline in energy prices caused by the recession in Asia made for what was overall a net easing in financial conditions during the Asia/Russia/LTCM crises. This drove a significant acceleration in domestic demand that more than offset the drag from a substantial slowdown in exports.

With US Treasuries a key flight to safety beneficiary during global market turmoil, the US economy can show greater

25



resilience to overseas market weakness, with declines in domestic interest rates helping offset weakness in domestic risk assets to cushion the impact of external shocks on overall financial conditions.

What’s different this time around?

Most of the lessons from the late-1990s are still relevant today. The behavior of the risk premium in risk assets and the flight-to-safety bid for Treasury securities likely bolstered by the Fed’s response will still be the most important aspect of an EM shock. Exports, however, are more important today, with a sizeable contribution of net exports to US growth, despite strong domestic demand. Nearly 43% of total US exports are destined for EM economies, and this has been the fastest-growing part of exports. Further, the starting point for US growth is much weaker than it was in the late 1990s, and the lingering threat of deflation still creates concern about the impact of a deflationary EM shock.

The lesson from the 1990s for the Fed was that the reversal of policy from a prospective hiking cycle to a rate cut was probably excessive. This time around, the Fed is already keenly watching EM risks – and its communiqués have mentioned as much explicitly – but whether it will be reactive or proactive in dealing with the threat of an EM shock is the main question.

Will the Fed be proactive or reactive if it sees EM risks rising?

Immediate policy response: We would expect the Federal Reserve to adopt an appropriate policy response should financial spillovers materially increase the downside risks to the US outlook. Forward rate guidance is the first line of defense – stronger, more assertive assurance that rates will remain low for even longer. Additionally, the Fed has stressed that longer-term asset purchases are not on a pre-set course and remain data dependent. Should the incoming data materially undershoot the Fed’s expectations, the tapering of purchases will stall.

Credit crisis policy response: If there are increasing signs that EM contagion threatens to trigger a credit crisis in the US, the Federal Reserve would act swiftly and forcefully to counter any threat to the stability of the US financial system. First, strengthening its oversight and supervision of the US banking system would allow the Fed to quickly detect threats to the solvency of large financial institutions. Additionally, even if the US banking and financial system appears to be weathering the initial shock waves hitting EM economies, the Fed would

likely join with other central banks to ensure liquidity across the global financial system.

Acting under the powers granted it by the Federal Reserve Act (and amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010), the Board of Governors of the FOMC can act promptly to provide liquidity to financial markets as a means of minimizing contagion from isolated instances of insolvency of one or more financial institutions. For example, the Federal Reserve would likely encourage eligible institutions to make full use of the Fed’s discount window by lowering the discount rate from its current level of 75 basis points and to re-open the Term Auction Facility. The Federal Reserve would also likely extend, expand, or lower the rate on the Central Bank Liquidity Swaps that are currently in place. As with the Term Auction Facility, actions related to the Central Bank Liquidity Swaps require no special action by other authorities.

Other options are available to the Federal Reserve, but would now require the Treasury Secretary to approve the invocation of the “exigent circumstances” clause of Section 13 (3) of the Federal Reserve Act (a provision included in the Dodd-Frank legislation). Seeking this authorization could potentially delay the timely implementation of a more extensive liquidity program. Nevertheless, if conditions warranted, the Federal Reserve could seek authorization to channel credit directly to other entities that are not eligible financial institutions. This option would be similar to lending programs used at the height of the financial crisis such as the Primary Dealer Lending Facility and the Term Asset-Backed Lending Facility.

What would an EM shock do to US growth?

Our simulations assume an EM shock first hits US growth in 2Q14 and that growth is lowered by an average 1.4 percentage points (pp) four quarters hence. Exhibit 54 details the growth difference by quarter over the forecast horizon.

Model simulations take into account the direct effect through the international trade channel, which is then partly offset by an accompanying decline in commodity prices, as well as effects through the credit channel (i.e. tighter financial conditions), which trigger a monetary policy response.

Exhibit 54

US: GDP impact of an EM shock

QoQ SAAR 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15

Drag on growth (pp) 0.0 -1.3 -1.8 -2.2 -0.3 0.3 0.5 0.1 Source: Morgan Stanley Research estimates

26



These simulations include the assumption that exports to EM+China drop by a total of 15% over three quarters, starting in 2Q14. This is approximately double the decline seen in 1998 during the Asian financial crisis, and is intended to capture the growing share of US exports to EM+China over time. We then include the response from global commodities and lower the price of Brent crude to US$80/bbl over two quarters beginning in 2Q14 before allowing prices to fully recover to previous estimates by the end of 2015. Taken alone, the hit to US exports shaves off an average 1.0pp from annual GDP growth four quarters hence, but this impact lessens to 0.4pp when adjusted for the commodity response.

Next, we introduce a measure of overall financial conditions to capture tighter credit conditions in the US. To capture the financial channel, we shock the VIX (CBOE Volatility Index) by doubling it in 3Q14, which then triggers a monetary policy response. This assumption is similar to the jump seen in the VIX in 3Q98, which coincided with the start of a monetary policy easing cycle in the US. Adding in the financial channel brings the total hit to annual GDP growth four quarters hence to an average 1.4pp, as noted above. Exhibit 55 summarises these impacts in greater detail.

Exhibit 55

Impact of an EM shock on average annual US GDP growth (percentage points) Exports to EM+China drop by a total of 15% over three quarters starting in 2Q14 (recover over the forecast horizon, but do not reach previous peak)

4 quarters hence

-1.0

2014 2015

Year-on-year -0.7 0.2

Q4/Q4 -1.3 1Exports to EM+China drop by a total of 15% over three quarters starting in 2Q14 (recover over the forecast horizon, but do not reach previous peak) Brent declines to US$80 over two quarters starting in 2Q14 before recovering to previous estimated level by end of 2015

4 quarters hence

-0.4

2014 2015

Year-on-year -0.4 0.1

Q4/Q4 -0.7 0.2Exports to EM+China drop by a total of 15% over three quarters starting in 2Q14 (recover over the forecast horizon, but do not reach previous peak) Brent declines to US$80 over two quarters starting in 2Q14 before recovering to previous estimated level by end of 2015

VIX shock of 30 (doubling) in 3Q14 then MP response kicks in

4 quarters hence

-1.4

2014 2015

Year-on-year -0.6 -0.7

Q4/Q4 -1.3 0.2Source: Morgan Stanley Research estimates

27



Euro Area: Modest EM exposure still makes for recession risk

Elga Bartsch, Daniele Antonucci, Olivier Bizimana

The euro area faces the risk of a recession with consecutive quarters of negative growth.

The drag on growth is sharp, but FX weakness and lower bond yields provide an offset that helps push growth higher in 2015.

The deepening division of labour internationally since the 1990s has increased the exposure of euro area countries to emerging market economies. Yet, the direct trade and business linkages as well as the financial linkages remain relatively modest, especially with those economies that our EM colleagues term the ‘double deficit club’ – primarily Brazil, India, Indonesia, South Africa and Turkey. Hence, our estimates show that an adverse economic shock emanating from emerging markets would only have a meaningful impact on the euro area if it causes serious contagion to developing markets more broadly and also leads to significant turbulence in global financial markets. In our simulations, we take into account the direct trade linkages but also third market effects as well as repercussions for the exchange rate and asset price fluctuations, notably in government bond and corporate credit markets.

Below, we discuss the different channels of contagion in isolation and then present the results of our model simulation.

Relatively small, but growing direct trade linkages

The direct trade exposure to EM has increased materially over the past 20 years, but remains relatively small. Euro area merchandise exports to the BRIICS (Brazil, Russia, India, Indonesia, China and South Africa) and Turkey amounted to about 10% of total exports in 2012, compared with around 5.5% in the mid-1990s. This is equivalent to 0.9% and 0.3% of GDP, respectively. Among the larger euro area countries, Germany has the highest exposure, with around 14% of its exports going to the BRIICS and Turkey in 2012. Germany has also recorded the strongest increase in direct trade with these economies, with the share of exports doubling since the mid-1990s, thanks to trade with Russia and China.

More significant financial linkages, but not alarming

Financial linkages are likely to amplify the effects of a growth slowdown in the emerging market economies. The share of euro area external assets held in large emerging markets has

increased since the 1990s. For example, the share of euro area foreign direct investment (FDI) held in the Brazil, Russia, India and China (BRICs) rose to 9% of total FDI in 2012 (versus 4.3% in 2005), while the share of portfolio assets in that region increased by about 2 percentage points (pp) to 4.5% in 2012. Given the relatively small share in the euro area’s overseas assets, the transmission of a marked EM slowdown to the euro area would likely be relatively limited.

A slowdown in emerging markets would dent the foreign affiliate sales (FAS) of euro area companies. On average, around a third of the revenues generated by euro-area listed companies are derived from the emerging markets. Only about 14% of their revenues emanates from the large emerging economies – the BRICs, according to our Global Exposure Guide (European Strategy: Global Exposure Guide 2013, 28 May 2013). Within the core countries, Finland and Belgium’s companies have the highest exposure, with around 18-20% of their revenues deriving from the BRICs, while French and German companies’ revenues are similar to the average euro area. In the periphery, Portuguese, Spanish and Italian companies derived a significant amount of their revenue from large emerging markets as well, at around 15% of the total. Historically, FAS have mostly been affected by exchange rate moves. Often these changes in stated earnings were purely translational in nature (as a stronger EUR dented overseas earnings) without really affecting the underlying profitability of a euro area based multinational company producing locally. Only where profitability is affected materially would we expect negative repercussions for employment and investment at the companies’ headquarters.

Banking linkages could also transmit emerging market shocks to the euro area financial system. However, according to BIS data on foreign claims (on a consolidated, ultimate basis), exposure to large emerging market economies remains relatively modest, although it has increased meaningfully relative to the pre-crisis period. Among the large economies, Spanish banks appear to have the highest exposure, with about 12% of foreign claims on the BRIICS in 2013 (4% in 2005), reflecting mainly claims on Brazil (around 10%). Among core countries, banks in the Netherlands and, to a lesser extent, in France, appear to have sizeable exposure, with around 5% of foreign claims on the BRIICS in 2013.

28



Bottom line: Taken together, the different channels of EM crisis transmission signal risks of a renewed recession.

An escalating EM crisis would likely push the euro area back into recession. In our modeling, we take into account the direct effect through the international trade channel, which is partly offset by an accompanying decline in commodity prices and a subsequent material weakening of the EUR. We also assume a moderate tightening in financial conditions. Given that the weakening in the euro and the easing in commodity costs would likely insulate the euro area from some of the negative repercussions, we would expect the ECB to be conservative in its policy response. Back in 1997/98, the Bundesbank and the other European central banks did not react aggressively to EM turbulence. In fact, in late 1997, the Bundesbank raised rates by 25bp, a move that the Bank only reversed in late 1998.

Today, the ECB policy rate is already close to the lower zero bound, and additional policy options are relatively limited, in our view. Importantly, in the euro area outright QE is fraught with legal and political hurdles. Whether the ECB would feel the need to take such an aggressive step would be a very close call and would depend largely, we think, on how quickly the EUR and oil prices start to adjust downwards.

We estimate an EM shock would shave 0.6pp off annual average GDP growth in 2014, probably pushing the euro area back into a mini recession. Meanwhile it would leave the full year estimate for 2015 broadly unchanged, as the weaker EUR, lower oil prices, and lower bond yields would offset the impact of the contraction in EM demand. Exhibit 56 below shows the combined impact on the euro area GDP growth trajectory in detail.

Exhibit 56

Euro Area: ContagEM scenario


Base 0.2 0.2 0.6 1.0 1.2 1.2 1.2 1.2

ContagEM 0.2 -1.2 -0.2 0.1 2.6 1.7 1.2 0.7

Drag on growth (pp) 0.0 -1.4 -0.7 -0.9 1.4 0.5 0.0 -0.5

Annual Avg 2014 2015

Base (tentative) 0.5 1.1

ContagEM -0.1 1.2

Drag on growth (pp) -0.6 0.1 Source: Morgan Stanley Research estimates

29



Japan: Ups and downs – mostly downs

Takeshi Yamaguchi, Robert Alan Feldman

Japan, like the euro area, could face a recession, with consecutive quarters of negative growth and a drag on growth that extends into 2015.

EM accounts for 70% of Japan's exports (China alone accounts for 23%) which makes the export channel more important than in the US and the euro area.

A policy response from the BoJ as well as lower commodity prices would help, but a growth shock from EM would make escaping deflation much harder.

A significant slowdown in EM nations would harm Japanese growth quite substantially. We estimate the drag on Japanese growth in 2014 from an EM slowdown at 1.2 percentage points (pp). Given the already low growth trajectory we have for 2014, such a scenario would push Japan back into recession and make escape from deflation even harder. In this scenario, a major easing of monetary policy would come quickly, but fiscal policy would be harder to adjust, because Japan has already committed to hiking the consumption tax by 3 pp on April 1. With this background, and with a further 0.4 pp drag likely in 2015, Prime Minister Abe would likely postpone the next tranche of consumption tax hikes, now scheduled for October 2015.

The reason for the large impact on Japanese growth is simple: emerging markets account for 60% of Japan’s exports, with China alone at 23% and Asia ex China at 31%. Moreover, to the extent that an EM slowdown impacts Europe and the US, feedback effects would worsen the overall outcome further.

There is one silver lining for Japan, however: Japan’s import structure is heavily skewed toward commodity imports (49% of the total), particularly fuels (33%, about Y27tn – US$270bn). To the extent that an EM slowdown pushes commodity prices down, Japan would benefit. For example, if average fuel prices fell by 25%, Japan would save the equivalent of about US$67bn from price movements alone. Granted, the trade balance would probably not improve, in light of the drop in exports, but at least there is a cushion to the impact on Japan.

How conditions for Japan today differ from 1997 (and don’t differ)

For Japan, it is tempting to draw parallels between 1997 and 2014. Both years saw shocks to Asian economies, at a time when domestic demand faces downward pressure from a hike in the consumption tax. Japan’s room for fiscal maneuver is again limited by large fiscal deficits, and a more aggressive stance on structural reform has to yet to materialize. There is, however, one beneficial similarity – a weak yen.

All that said, the differences with 1997 outweigh the similarities. Beneficial differences include the strong Japanese financial system, with low levels of non-performing loans, and much stronger balance sheets in counterpart institutions in Asia. Crucially, Japan has a stable government, with the ruling coalition taking strong majorities in both houses of the Diet. The monetary authorities have switched to an aggressive anti-inflation stance. At the corporate level, financial ratios are

Exhibit 57

Japan: ContagEM scenario


Base 3.3 -3.0 0.6 1.5 1.1 1.8 2.8 -1.1

ContagEM 2.0 -5.4 -2.9 2.0 1.4 1.7 1.8 2.2

Drag on growth (pp) -1.4 -2.4 -3.5 0.5 0.3 -0.1 -1.0 3.4


Base (tentative) 0.9 1.1

ContagEM -0.3 0.7

Drag on growth (pp) -1.2 -0.4 Source: Morgan Stanley Research estimates

30



much improved, while interest rates remain low. In contrast, adverse differences include a tenser geopolitical situation in the region, high energy prices, supply constraints in the wake of the Fukushima accident, a shrinking labor force, and loss of global market share in important industries like electronics.

In our view, the beneficial elements, relative to 1997, far outweigh the adverse ones. Thus, even though a major impact on Japan from a sharp EM slowdown would be inevitable, a shock of the same size as 1997 would likely have less impact on Japan today than it did back then.

Exhibit 58

Japanese export structure, by country Exports, Yn Tln

0

20

40

60

80

100

Jan/

05

Jul/0

5

Jan/

06

Jul/0

6

Jan/

07

Jul/0

7

Jan/

08

Jul/0

8

Jan/

09

Jul/0

9

Jan/

10

Jul/1

0

Jan/

11

Jul/1

1

Jan/

12

Jul/1

2

Jan/

13

Jul/1

3

Jan/

14

China+HK Non-China Asia USA EU28 Other

Source: Ministry of Finance, Morgan Stanley Research calculations

Exhibit 59

Japanese import structure, by product Japan Imports (Yn Trl)

0

30

60

90

Jan

/01

Jan

/02

Jan

/03

Jan

/04

Jan

/05

Jan

/06

Jan

/07

Jan

/08

Jan

/09

Jan

/10

Jan

/11

Jan

/12

Jan

/13

Noncommodity Food Raw Materials Fuels

Source: Ministry of Finance, Morgan Stanley Research calculations

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Australia & New Zealand: Hit to exports and expectations

Daniel Blake, Sung Woen Kang

Australia would experience a substantial drag on growth, with a 2% average quarterly drag on growth in the four quarters after the shock, in our scenario.

The Australian economy would likely flirt with recession, and only the RBA’s prompt action would keep growth north of zero for a couple of quarters.

New Zealand would be hit by both lower EM growth and lower growth in Australia (New Zealand's biggest trading partner). As a result, growth in New Zealand could face a drag of around 2% in 2014 too.

Rapid, commodity-intensive growth in EM economies over the last decade has provided a significant boost to the two economies down-under. Exports to EM have accelerated sharply, increasing both as a share of total exports and GDP for both economies since the late 1990s. This has been driven mainly by increased trade with China. Both countries received a significant boost to their terms of trade, with New Zealand setting new cyclical highs on strong dairy prices, while Australia’s terms of trade are normalising after seeing much stronger upswings through 2008 and 2011 on iron ore and coal prices. A shock to the profile of EM growth, particularly one including China, would have a substantial impact on both countries’ growth and currency outlook.

Australia: ContagEM scenario

In this scenario, Australia is likely to take a sizeable hit to growth during 2014 and 1H15, with the near-term impact pushing the economy to flirt dangerously with recession and remain entrenched in weak growth throughout the forecast horizon. In spite of likely aggressive monetary and fiscal policy easing and a depreciating AUD, we estimate annual average GDP growth would more than halve to 1.0% in 2014 and 1.2% in 2015. The key channels of impact for Australia would be through the terms of trade, wealth and confidence/expectations effects, and a steeper decline in resource-sector investment.

Quantifying the potential impact on Australia’s terms of trade, our commodity strategists see the ContagEM scenario taking iron ore prices down to US$84/t and copper to US$2.60/lb. Incorporating the breadth of commodity price impacts across Australian export markets, we expect the terms of trade to decline by approximately 10%, which would strip 2 percentage points (pp) of real gross domestic income from our base case.

We believe the impact of a ContagEM scenario on Australian export volumes would be quite limited, given the bulk of Australian exports to EM are concentrated in raw materials (where Australia sits low on the cost curve, putting the burden of the volume adjustment on others) and services (tourism would be impacted, but education should be quite resilient).

Exhibit 60 Australia and NZ exports to EM

Exports to EM, % GDP

4%

6%

8%

10%

12%

1996 1998 2000 2002 2004 2006 2008 2010 2012

Australia

New Zealand

Exports to EM, % GDP

0%

2%

4%

6%

8%

10%

12%

Australia NZ Australia NZ

1997 2012

Exports to China, %

Source: IMF, Morgan Stanley Research

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However, with the resources sector likely to curtail remaining expansion plans, we would see a smaller contribution of exports to growth.

In terms of policy reaction, we expect the RBA would use its remaining 2.5 pp of headroom on the official cash rate, which would allow it quickly to inject about 4% of additional household disposable income through reduced debt service, helped by the largely variable mortgage and personal loan rate structure. And while the government has been focused on returning the budget to surplus (from a projected deficit of 3% and net debt at 12% of GDP this year), we believe a shock of this magnitude would afford the political space to let the automatic stabilisers run, and potentially further boost government infrastructure spending to support demand.

Lastly, the AUD has operated as an effective hedge to external shocks in the past, and we believe it would again depreciate to help shield the effect of the declining terms of trade on domestic incomes and assist in rebalancing demand internally. This would come at a cost to households’ purchasing power and impact consumption levels, but would help diffuse the shock globally (through reduced Australian outbound tourism and consumption of imported goods).

New Zealand: ContagEM scenario

New Zealand is likely to feel an immediate double impact on growth via subdued demand from China/EM as well as indirectly from Australia, its largest trading partner. We estimate annual average GDP growth in this scenario would take a significant hit to 1.0% in 2014 and 1.2% in 2015. Like Australia, New Zealand has ample room for fiscal and monetary policy implementation designed to mitigate the shock, while currency depreciation would help engineer a broader rebalancing in the economy. Furthermore, services exports in the form of tourism and education are likely to remain

resilient. Unlike Australia, New Zealand is a net importer of petroleum products (mineral fuel imports make up 17% of total imports at NZ$8bn) and it would benefit from potential declines in energy prices associated with a slowdown in the EM region. In addition, to the extent that soft commodity export prices (for example, dairy products) remain relatively high given their linkage to consumer staple demand, there would be less of a drag on New Zealand’s terms of trade.

In Australia, we expect a strong net export tailwind to continue from the resources investment that is coming on stream. Assuming support from a weaker AUD and given Australia is operating low-mid on the cost curve, export volume increases will likely compensate for declines in terms of trade, thereby protecting headline GDP by around 1pp. We expect curtailed expansions and resources projects to be a 2015 story, at the next expansion phase. To this end, private investment is likely to retain its strength in 2014. However, we expect to see a meaningful hit to confidence and wealth effects through a fall in global and Australian equity markets. When coupled with the weaker AUD, we expect consumption and imports to be substantially lower than our baseline.

In New Zealand, a sharp depreciation of the currency would bring it back to more ‘sustainable’ levels and provide support for exports, although we expect reduced global demand for the country’s products and dampened business and consumer sentiment domestically to put downward pressure on investment and employment, helping to keep inflation in a reasonable range. How the New Zealand housing market would react is a key question, as it would have an impact on both household consumer demand via the wealth/confidence effect and residential fixed investment. A sharp reversal in housing prices would prove disruptive for financial stability and would have magnified negative repercussions on the wider economy.

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Exhibit 61

Export shares, by destination

Australia Export Share by Destination, 2012

0%

10%

20%

30%

China

Japan

Korea

India

EMU US

Taiwan NZ

Singapore UK

New Zealand Export Share by Destination, 2012

0%

5%

10%

15%

20%

25%

Australia

China

US

Japan

EMU

Korea

UK

Malaysia

HK

Indonesia

Source: IMF, Morgan Stanley Research

What’s different from the 1990s?

Both Australia and New Zealand were relatively resilient in the face of the Asian financial crisis in the late 1990s. In particular, Australia experienced buoyant domestic demand and external growth on the back of a strong household and mortgage credit cycle and an elongated RBA easing cycle after hiking rates to 7.5% in response to the inflation and bond scare of 1994. On the other hand, New Zealand suffered from adverse weather conditions in 1997-98, and its monetary policy was hiked aggressively through 1998, which caused it to fall into recession – arguably as a result of a policy mistake.

Would this time be different? EM now makes up roughly 59% of Australia’s exports and 37% of New Zealand’s, with China alone accounting for 30% and 15%, respectively. An EM slowdown would also further depress growth via negative feedback effects on other developed markets, such as the US and the euro area, as well as key North Asian trade partners such as Japan, Korea and Taiwan. This would be a worrying scenario, given both economies’ GDP growth profiles are at lower starting points now compared to the late 1990s.

Exhibit 62

Australia: ContagEM scenario


Base 2.1% 1.7% 4.3% 6.8% 3.3% 1.7% 3.5% 6.4%

ContagEM 0.5% 0.1% 2.3% 4.0% 0.9% 0.1% 3.1% 4.8%

Drag on growth (pp) 1.6% 1.6% 2.0% 2.8% 2.4% 1.6% 0.4% 1.6%


Base (tentative) 3.7% 3.7%

ContagEM 1.7% 2.2%

Drag on growth (pp) -2.0% -1.5% Source: Morgan Stanley Research estimates

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Asia ex Japan: High direct exposure to China

Chetan Ahya, Derrick Kam, Jenny Zheng

The AxJ region is highly exposed to the impact of a growth slowdown in China, as China has emerged as a key source of end demand over the past six years.

Within the region, Korea, Taiwan and Singapore would be most affected via the direct trade channel, while Indonesia and Malaysia would be affected via the commodity price channel, owing to their status as the net commodity exporters in the region.

The twin headwinds arising from a growth slowdown in China and the rise in US real rates would pose downside risks to the growth outlook in the region ex China of around 1 percentage point on a QoQ basis, we estimate.

Although external stability is in better health than in 1997-98 and various regional institutional arrangements (such as the Chiang Mai Initiative) have since been put in place, we see the rapid rise in leverage as a key area of concern for AxJ.

1) Impact of a growth slowdown in China

China has played a key role in the region’s development over the past three decades. China’s GDP growth has averaged 10.2% over the past 30 years, and its share in the AxJ region’s nominal US dollar GDP had increased to 60% in 2013 from 41.3% in 2002 and 27.1% in 1992. The region’s dependence on China has also increased sharply over the past six years, as China emerged as a key source of end demand at a time when the US, Europe and Japan slowed significantly post the credit crisis.

Impact #1: Direct trade linkages As China’s domestic demand growth picked up post credit crisis, the share of China in the region’s exports has risen to 23% in 2012, from 21% in 2008 and 20% in 2003. In this analysis, we have taken the combined exports to China and Hong Kong, as Hong Kong is a trading hub that redirects the majority of its exports to China. The increase in domestic demand in China is also reflected in the pick-up in imports that are not related to the processing trade. Hence a slowdown in China’s domestic demand will slow import growth and will have an attendant impact on the export growth of its trading partners. Within the region, the economies that have the highest direct trade exposure to China are Taiwan, Korea and Singapore.

While a slowdown in China’s imports will have attendant implications for these countries’ export growth, the impact of weaker exports to China will be manifested slightly differently. In the case of Australia, the key link will be via the commodity price linkage. In the case of Korea and Taiwan, our economist, Sharon Lam, believes that Korea is likely to be affected more than Taiwan in a China slowdown scenario because Korea’s exports to China are mainly for China’s domestic consumption and investment. Taiwan, on the other hand, as a global major tech component supplier, uses China as a re-export base. While we have analysed the direct trade exposure of the rest of the region by looking at the combined exports to China and Hong Kong, we believe that Hong Kong’s role as a regional trading hub will mean that it will also be impacted by a slowdown in China.

Impact #2: Commodity linkages China’s strong investment growth has played a key role in the trend for industrial commodity prices. China continues to contribute strongly to the demand for these key industrial commodities: it accounted for more than 50% of the growth in these commodities in 2012. In this context, the net commodity exporters in the region such as Australia, Indonesia and Malaysia will be most affected. We believe that the impact of slower growth in China will be transmitted via lower commodity prices, which will have an impact on 35-60% of the export baskets of Australia, Indonesia and Malaysia. More crucially, weaker commodity prices will affect the terms of trade negatively for these countries and could keep overall trade and current account balances weak, exposing the countries to funding risks, particularly Indonesia.

Impact #3: Financial linkages While the region’s financial linkages with China have also increased over the years, this has generally lagged the development of trade linkages. Hence, we believe that the financial market linkages are likely to be less meaningful than the direct trade linkages and commodity price impact. Indeed, according to our China Banks team, the overseas assets of the big four Chinese banks account for US$762mn or 7.9% of total assets in 2012, compared to US$354mn or 5.7% of total assets in 2009. We believe that the impact via financial linkage will likely affect Hong Kong and Singapore more, given their status as regional financial hubs.

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2) Impact of a rise in US real rates and US dollar

In addition to the challenge of slowing growth in China, we believe that the region is already facing another challenge in the form of the rise in the US dollar and real rates. We believe that the rise in US interest rates and US dollar strength, coupled with AxJ’s narrower current account surplus, will mean that the AxJ region will now face currency depreciation pressures alongside upward pressures on its real interest rates. We believe that all countries in the region will face a challenge on this front. The speedier rise in US real rates and dollar has now pushed Asia to lift its real rates at a time when its GDP growth has already been slowing – in other words, a pro-cyclical tightening of monetary policy. We think this is only increasing the headwinds to the region’s growth – particularly given the rapid buildup of leverage in the region over the past few years when real rates were kept low.

We have tried to assess the impact of this trend on three parameters: current account balances, reliance of funding structure on foreign capital, and the trend in bank lending (leverage) over the past five years when real rates were low. On these parameters, we believe India, Indonesia, Hong Kong, Singapore and Thailand would be more exposed to this trend within the region.

Our analysis suggests that within AxJ, countries with current account deficits are facing greater immediate pressures due to funding risks. Yet the continued upward pressures on real rates in the region will slowly but surely be felt across the region. Countries that have levered up meaningfully over the past few years when real rates were low will also be exposed. These metrics indicate that India, Indonesia, Thailand, Hong Kong and Singapore will be most exposed.

Twin headwinds of US dollar rise and China slowdown could bring major downside risks to the region’s growth outlook

We believe that the risks of a potential slowdown in China and the trend of a rising US dollar and rates could pose major downside risks to the region’s growth outlook. We believe that every country in the region will be exposed to at least one of these two trends, if not both. Within the region, we believe that the countries that will be most exposed to both these trends are Hong Kong, Australia, Indonesia and Singapore. Korea, India, and Thailand will be moderately exposed, while on a relative basis Taiwan and Malaysia will be less exposed to these two trends.

3) How would it be different from 1997-98?

With the exception of India, the countries in the region are not facing any major issues on the inflation front. Moreover, the external balance sheet (which was the key concern in 1997-98) is in a much better shape today, as the region is still running a current account surplus (as opposed to a deficit in 1997-98), while the region’s9 external debt to GDP has more than halved from 37% in 1998 to 16% in 2013. The higher level of FX reserves and more flexible exchange rates also mean that most countries in the region are better placed in this cycle in terms of their external balance sheet. Moreover, regional institutional arrangements (such as the Chiang Mai Initiative) and bilateral arrangements between central banks in the region point towards a better institutional capability to deal with an external shock.

Despite these mitigating factors, what concerns us in this cycle is the sharp uptick in leverage over the past six years. In particular, the region’s weakening demographic trends (rising age dependency) and the disinflationary pressures will mean that nominal GDP growth will likely be weaker and will thus complicate the management of debt dynamics for the region10

.

9 Excludes Hong Kong, Singapore and Taiwan. We exclude Hong

Kong and Singapore as their high levels of external debt to GDP

reflects their role as the regional financial hubs. Data for Taiwan is only

available from 1999. 10 see Asia Pacific Economics, Asia Insight, Asia’s Debt Indulgence,

Feb 24, 2014 for more details)

http://linkback.morganstanley.com/web/sendlink/webapp/static/research/article/index.html?b=Y2g9T3V0bG9vayUyMEJsYXN0bWFpbCZjdT0wM0NIVyZpZD01ODIyNTA%3D&d=f%2F6dsf621q-3ost-g000-aac9-984be168e400%3Fstore%3D0%26d%3DUwBSZXNlYXJjaAA1ODIyNTA%253D%26user%3Dc74xk4u

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Latin America: Commodity price linkages are key

Gray Newman, Luis Arcentales, Arthur Carvalho, Daniel Volberg

Latin America is less directly exposed to China’s end demand. But with the majority of its exports basket commodity related, a growth slowdown in China would affect the region via weaker commodity prices and a negative terms of trade impact.

Domestic demand could be further affected via weaker consumer purchasing power and reduced attractiveness of commodity- related investment. Government spending could be constrained be weaker commodity tax revenues.

The current account deficits in the region suggest some vulnerability to rising US real rates, although this could be mitigated by the availability of stable funding sources and closer integration with US economic cycles.

As with Asia ex Japan, Latin America’s external balance sheet is now in better health than in 1997-98, although higher foreign participation in capital markets could pose a risk.


The key channel through which a growth slowdown in China would be transmitted to Latin America is the commodity price channel. Indeed, while the region’s direct trade exposure to China appears low, the impact via weaker terms of trade through lower commodity prices would have negative implications for the region, with a potential second-round impact via weaker purchasing power for consumers, commodity-related investments and public finances. Mexico excepted, we would expect the region to face downside risks to growth in an EM shock scenario.

With commodity exports accounting for a significant proportion of total exports for Brazil, Chile, Colombia and Peru, a weaker growth scenario in China would weigh on commodity prices and thus translate into a negative terms of trade shock for these commodity exporters. The one bright spot for Brazil is that it is a half metals, half agricultural commodity exporter, and the latter are less sensitive to Chinese growth fluctuations. Its more diversified commodity exports could mean that Brazil suffers less of an impact from a China slowdown than the pure metal commodity exporters, Chile and Peru. Nonetheless, a growth slowdown in China would have a negative impact on the outlook for the net external demand of these economies and would exert direct downward pressure on the growth outlook.

The weaker terms of trade would not only affect the commodity exporting sector but could have a second-round impact on the economy via three separate channels. First, the impact of weaker terms of trade on the external balance could bring depreciation pressures for currencies in the region, weakening consumer purchasing power. Second, investment growth would also be affected in this scenario, as lower commodity prices reduce the attractiveness of FDI and commodity-related investment. To this point, our Brazil economist, Arthur Carvalho, estimates that 60% of investments in Brazil were commodity related up to 2012, while our Colombia and Peru economist, Daniel Volberg, estimates that 40-60% of the FDI in Colombia over the past decade has been driven by the oil and mining sector, while 50-60% of FDI in Peru is driven by the mining sector.

Third, weaker commodity prices would put pressure on public finances and could force the respective governments in the region to reduce expenditure growth in light of lower commodity-related revenues. In Brazil, lower growth could lead the government to consolidate fiscal policy as revenues contract. Taken together, these factors would suggest greater downward pressure on the region’s growth outlook in light of weaker commodity prices.

Within Latin America, Mexico would be least affected by a growth slowdown in China, unless the growth slowdown in China derails the US recovery. From an export standpoint, Mexico exports very little to China. Moreover, given that the expected investment from the oil reform is a 2015 story at the earliest, any downward pressure on oil prices arising from a China slowdown should be manageable.


The Latin America region will be affected by a rise in the US real rates owing to the current account deficits that the region runs. Funding risks would thus be transmitted via weaker currencies and higher rates, which could impact both investment and government expenditure. However, the impact of this funding risk would be mitigated if economies were able to rely on stable sources of funding to help fund their current account deficits. Another mitigating factor would be the nature of the rise in US real rates. If the rise were to be in a benign fashion (i.e. tied to a fundamental improvement in the US economy), the impact of the funding risks on Latin America could be more manageable, as it would be offset by better

37



growth prospects, given the region’s trade linkages with the US.

The countries most exposed to rising US real rates are Brazil and Peru, while Mexico and Colombia would be more insulated owing to resilient positioning (the Fed taper talks over the summer of 2013 did not trigger outflows from the bond market) and a more stable source of FDI inflows for Colombia.

3) How would it be different from 1997-98?

While the global economic background and transmission channels remain largely the same now as in 1997-98, a number of differentiating points suggest that economies in the region would be relatively more resilient today to external economic shocks. First and foremost, external imbalances (as measured by the size of current account deficits, external debt ratios and foreign exchange reserves) are healthier than in 1997-98. Second, one channel of adjustment, the exchange rate, is now more flexible than it was 1997-98. Third, economic management on both the fiscal and monetary policy fronts are now deemed to be more credible as compared to 1997-98.

One factor that could amplify the transmission, however, is the relatively larger size of foreign participation in the region’s capital markets.

Brazil: Brazil is a very different country, when compared to 1997-98. In 1997 it had a fixed exchange rate regime, whereas now it has a dirty float. Inflation targeting was only implemented in 1999, hence the most important inflation anchor in 1997-98 was a strong exchange rate that deflated tradable goods prices and allowed overall inflation to fall after two decades of hyperinflation. However, the artificially strong exchange rate created a large current account deficit, which was materially higher than today’s 3.7% of GDP. All external vulnerability measures for Brazil are significantly better today, mostly due to the stock of US$377bn of FX reserves. Moreover, Brazil is now a net creditor in US dollars, as compared to the 1990s, when 15-20% of Brazil’s internal debt was FX linked.

However, Brazil today has more foreign investors holding its debt than in the 1990s, and it still has a substantial amount of onshore capital. There is US$204bn in equity and US$112bn in fixed income held by foreign investors. We see this as the major risk for Brazil in this scenario.

Mexico: Mexico’s currency was already floating in 1997-98, and on a REER basis FX levels today do not suggest a misalignment. External vulnerability measures such as public sector external debt have improved to 10% of GDP today, compared with close to 25% of GDP back in 1996. FX reserves are also much healthier today, at US$180bn (15% of GDP), compared with just US$20bn (5% of GDP) at the start of 1997. As in Brazil, an important external vulnerability for Mexico today is that foreign investors hold roughly US$140bn (11% of GDP) in local government bonds. A factor that has probably not changed since 1997-98 is the level of Mexico’s integration into the US industrial cycle, as suggested by trade figures: ~85% of total exports went to the US back then versus ~80% today.

Chile: Chile has a free float exchange rate arrangement today, but had a crawling peg in 1997-98. Arguably, the exchange rate has already adjusted in a significant way, whereas back in 1997-98 the central bank had been defending it – including narrowing the band from 25% to 5.5% in mid-1998 due to fear of pass-through – until the policy became unsustainable. It remained in place until September 1999. Reserves, not surprisingly, were declining as the central bank attempted to defend the currency (they fell from US$19bn+ in late 1997 to sub-US$15bn by 1999). The target of keeping the exchange rate within the band forced the central bank to hike rates significantly (to 14%). Today the central bank is actually easing rates and has become more dovish, despite the meaningful exchange rate depreciation. The external balance sheet is also in better health today, with the current account deficit at 3.6% of GDP on our 2013 estimates, as compared to a deficit of 6.5% of GDP in the 12 months to 2Q98. Arguably, the economy was more vulnerable to terms of trade shocks in 1997-98, as external financing played a more relevant role then than it does today.

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CEEMEA: Less directly exposed to a China growth slowdown

Tevfik Aksoy, Pasquale Diana, Michael Kafe, Andrea Masia, Jacob Nell, Alina Slyusarchuk

The CEEMEA region is less directly exposed to China’s end demand, with the exception of South Africa (China is its largest trading partner).

Rising US real rates would probably invoke a higher beta reaction in Turkey and South Africa, while Russia, Poland and Hungary would see a smaller magnitude of rise in bond yields.

A better price and external stability environment and greater policy flexibility means that the region is better placed than in 1997-98 to withstand this external shock.


The CEEMEA region’s direct exposure to China’s end demand ranges from negligible (Turkey, Poland, Hungary) to small (Russia) to substantial (South Africa). However, in the case of Hungary and Poland, we believe that there is the scope for traditional export data to understate the share of trade with EM Asia and overstate the share of trade with Germany. This is because of Central Europe’s role in the German industrial supply chain, as semi-finished goods leave Central Europe and head towards Germany for final re-export somewhere else, very often to China. Moreover, the impact of a growth slowdown in China and its impact on commodity prices (particularly oil) could provide some offset to the negative terms of trade shock, especially for oil importers such as Turkey.

In a similar vein, if the growth slowdown in China were to result in a bout of increased risk aversion, the impact on the overall funding structure of CEEMEA would also be quite diverse. Increased risk aversion would hurt Turkey and South Africa if overall funding conditions deteriorate. While Poland and Hungary would also be affected quite severely in the event of greater risk aversion in financial markets, they are to some extent cushioned by external surpluses if we add up their current and capital accounts (the latter being mostly EU funds). In contrast, Russia has comparatively little dependency on external funding with a current account surplus, balanced budget and a positive international investment position. In this case, the risk would be further outflows from bonds (foreign ownership is 25% of local government bond market) and equities.


The rise in the US dollar and US real rates would also be transmitted to the CEEMEA region to varying degrees. Bond yields in South Africa and in Turkey would likely move by a larger magnitude relative to US real rates, while currencies could weaken significantly. In contrast, Hungarian and Polish rates would rise, but arguably would be more resilient than most of their CEEMEA peers, given better external positions and fundamentals. In Russia, the net effect on the overall costs of funding for the government sector would probably be neutral, given that the rise in the cost of government bond issuance would likely be offset by increased returns on reserves, mainly in the oil funds, which are invested in DM government bonds. Domestic lending rates would probably stay flat, with falling inflation offsetting the impact from higher US rates.

3) How would it be different to 1997-98?

Price stability is much less of a concern than in 1997-98, when many countries in the region were experiencing high double-digit rates of inflation. On external stability, current account positions are healthier than they were in 1997-98, with the exception of Turkey and South Africa, where the current account deficit is much wider now than was in the late 1990s.

More flexible exchange rate arrangements and more prudent management of fiscal policy (with the exception of South Africa) imply that there is greater policy flexibility to help facilitate the adjustments of the region’s economies.

Turkey: Inflation in Turkey is much less of a concern today, as compared with 1997 (when it was 85% YoY, versus single digits today). The transition to an Inflation Targeting regime, better fiscal and monetary policy implementation, lower FX-pass through and the removal of backward indexation of prices have helped to keep inflation largely in check. Today, the banking sector is profitable, balance sheets are strong, with no direct exposure to FX fluctuations. Although the current account deficit has long been an issue, it is a greater issue today as compared to 1997. More important, the large exposure of foreign investors to Turkish assets and the nature of funding of the external deficit make the country more exposed to an EM-wide risk than in 1997. On the policy front, in 1997-98 monetary policy was opaque, with a managed float that did not help in achieving price or currency stability. Today

39



the exchange rate is fully flexible, monetary policy is more complex but transparent, while fiscal policy is prudent with a very low deficit.

South Africa: South Africa’s current account deficit is now much wider than it was in the late 1990s. External debt is also higher, as are the foreign holdings of ZAR bonds. Policy scope is also limited, with policy rates much lower than in 1997-98, while the fiscal deficit was lower in 1997-98 than it is today.

Russia: Inflation is now less volatile and lower (in single digits) than it was in 1997-98, and a positive real rates environment suggests a lesser need for upward adjustment. Moreover, with oil prices higher today at around US$110/bbl compared to US$12-18/bbl in 1997-98, and balance sheets much stronger, the economy is arguably more resilient. FX reserves can provide for 19 months of import cover, compared with 5.5 months in 1998. On the policy front, the exchange rate regime is much more flexible, while the balanced budget and its position as a sovereign creditor with more reserves and lower debt (10.6% of GDP in 2013) suggest greater policy scope than in 1999, when the fiscal deficit was wide and government debt was high at 93% of GDP.

Poland and Hungary: The implementation of inflation targeting regimes has improved the ability of central banks in both these economies to bring inflation under control. In Poland in 1997 inflation was falling gradually from over 20% and only fell below 10% in late 1998, meeting the NBP’s inflation target. Today, Poland is enjoying record low inflation,

and the NBP has a strong reputation for inflation targeting. In Hungary, inflation targeting was adopted in 2001. In the late 1990s, Hungary was also dealing with inflation, which was falling from elevated levels (20%+), although not as fast as in Poland. Today, Hungary has limited inflation and now has a good chance of stably anchoring expectations around the target.

While external metrics point towards a weaker external balance sheet for Poland, the key macro difference between 1997 and today for both Poland and Hungary is in the process of ‘opening up’ to outside investors. During this process, any investment (FDI mostly, but also interbank funding) would have only added to external debt, which in turn reflects the tendency of small open economies to have a high external debt ratio. Moreover, in CEE’s case, much of this external debt is arguably in the ‘stable’ form of FDI or intercompany loans.

On the policy front, currencies were managed back in 1997-98 (crawling peg in Poland and Hungary). Managed devaluations during that period were seen as: 1) compatible with still bringing inflation down, by anchoring FX expectations; and 2) not harming external competitiveness. Today, the free floating nature of the exchange rate would mean that it would bear the brunt of any adjustment. On the fiscal policy front, debt/GDP is higher now than in 1997-98, but the government deficit is smaller. To be sure, the comparison with 1997-98 might not be that meaningful given that the Excessive Deficit Procedure exists today.

40



Strategy

41



Equity Strategy: Europe most exposed in DM

Graham Secker, Jonathan Garner, Adam Parker

European equity markets would be more adversely affected than the US and Japan.

Within EM, the equity markets in ASEAN, China, Chile and Poland are most dependent on growth in other EM economies.

At the sector level, in Europe, energy, metals, technology and staples have the highest exposure to EM. In the US, it turns out to be technology, energy, materials and industrials that are most exposed. Japan’s most exposed sectors are materials, consumer discretionary, technology, energy and industrial sectors.

EM equity markets are naturally more exposed to EM than the euro area, the US or Japan. The corporate sectors in Indonesia, Thailand and Malaysia derive more than 90% of revenues from EM. Next most exposed are corporates in China, Chile, Brazil and Poland. For Singapore, Taiwan and Russia, less than 60% of the revenues of listed equities come from EM.

We present regional stock screens showing the names with the highest EM exposure in the US, Europe and Japan.

Global Perspectives: Europe is highly exposed to EM; US and Japan less so … while EM equity markets show varying exposure

DM companies’ exposure to EM is higher now than in 1997 As highlighted elsewhere in this report, we do not believe that the macro backdrop in EM today is as bad as it was in the late 1990s. However, this good news is somewhat mitigated by the greater exposure and importance that emerging markets have assumed for DM companies over the past 15 years or so. For example:

i) Exhibit 63 shows that European companies now generate 33% of their revenues from EM, up from 12% in 1997.

ii) The correlation of MSCI EM to MSCI World (which is predominantly DM) has risen substantially from around 0.5 to nearly 0.9 over the past 15 years.

Exhibit 63 and Exhibit 64 show the two main sources of risk in terms of possible contagion from EM into DM, specifically a real economy effect through lower sales and/or correlation to EM asset price weakness. We look at both these linkages below for regions and sectors.

Europe generates the highest percentage of revenues from EM, Japan the least When we consider the revenue exposure of different DM regions by end market, our data suggests that Europe is most exposed with 33% of its sales derived from emerging markets, followed by the US at 18-24% and Japan at just 14%. For context, we estimate that around 90% of sales for EM companies come from emerging markets.

65-80% of European revenue growth has come from EM in recent years In addition to the absolute proportion of revenues that now originate from EM, we have looked at the contribution to top-line growth for Europe and the US. As shown in Exhibit 66 the weak domestic growth backdrop in Europe has meant that EM has accounted for somewhere between 65% and 80% of revenue growth in recent years. In the US, not only is the EM contribution to growth lower, it has also fallen quite materially in recent years as the US economy has rebounded (see Exhibit 65).

… and it’s the same story when we consider the correlation of performance to EM debt spreads This pecking order of DM exposure to EM is broadly mirrored when we look at the correlation of price performance of the regions against EM debt spreads – we are using the latter as the best market proxy for EM stress at this time. The bar chart in Exhibit 678 shows the weekly correlation (over the last five years) of regional price performance to the EMBI+ spread. Europe shows the largest (negative) correlation, the US is just behind, and Japan again shows the weakest link

42



Exhibit 63

European companies’ exposure to EM has nearly tripled in 15 years

8

12

16

20

24

28

32

1997 1999 2001 2003 2005 2007 2009 2011 2013

Eu

rope

ann

Com

pani

es -

% o

f To

tal R

eve

nue

s fr

om E

M


Exhibit 64

The correlation of MSCI World to MSCI EM has doubled since 1997

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13

Co

rrel

atio

n o

f M

SC

I Wo

rld

to

MS

CI

EM

Source: DataStream, Morgan Stanley Research

Exhibit 65

The proportion of revenue growth coming from EM has fallen materially for US companies

-20%

0%

20%

40%

60%

80%

100%

2009 2010 2011 2012

US

sto

cks

- %

con

trib

utio

n to

rev

enu

e gr

owth

from

EM

EM Europe US


Exhibit 66

EM/RoW has accounted for the majority of top-line growth for European companies in recent years

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2011 2012 2013 2014 2015

%p

t C

on

trib

utio

n t

o R

eal R

eve

nue

-We

igh

ted

Glo

bal G

DP

Gro

wth

(%

)

EM/RoW Europe US


Exhibit 67

EMBI+ debt spreads have been a good proxy for EM fears

200

250

300

350

400

450

Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14

EM

Deb

t S

prea

ds (

EM

BI+

)

850

900

950

1000

1050

1100

MS

CI

Em

ergi

ng M

arke

ts P

rice

Inde

x -

INV

ER

TE

D

MSCI EM - rhs - INVERTED

EM Debt Spreads (EMBI+)


Exhibit 68

Europe and US have highest correlation to EMBI+

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

Europe US Japan

Cor

rela

tion

of r

ela

tive

per

form

ance

to E

MB

I sp

read

s


43



Not all sectors are as sensitive to EM: Europe and the US are similar, Japan stands apart

In this section we move to look at the impact of an EM slowdown on regional sectors.

In the US and Europe, Tech, Energy and Materials have the highest sales exposure to EM. In Japan it is Financials and Consumer stocks First, in Exhibit 69 to Exhibit 71 we show the percentage of revenues each regional sector generates from EM end markets. Due to data limitations, the exact classification of ‘EM exposure’ varies a little across the different regions; however, any resulting discrepancies are small and do not alter the underlying conclusions from the analysis.

In the US and Europe there is a broad overlap, with three of the four sectors that generate the highest proportion of their revenues from EM being the same – namely Energy, Materials and Technology. The sectors with the lowest EM exposure are also the same for both Europe and the US – specifically Financials, Healthcare, Telecoms and Utilities.

In Japan, Materials, Consumer Discretionary, Information Technology, Energy and Industrials have the highest exposure to Asia ex Japan and the rest of the world ex Europe and North America. At the other end of the scale, Financials, Healthcare, Telecoms and Utilities have the lowest level of EM exposure in Japan, mirroring what we see in Europe and the US.

Across all of DM, Materials, Industrials and Consumer Discretionary are most correlated to EM debt spreads We have also run correlation analysis on regional sector relative performance to EM debt spreads (EMBI+). Across all three regions, Materials, Industrials and Consumer Discretionary are among the sectors most highly (negatively) correlated to EM debt spreads. It is also noteworthy that in the US and Europe Financials actually have the highest correlation to debt spreads; yet in Japan, where the sector has the highest sales exposure to EM, the correlation is more modest.

Exhibit 69





Energy 55.3% 2.2% 7.1% 35.4% 37.7%

Materials 52.7% 9.1% 16.2% 22.0% 31.1%

Industrials 62.1% 10.5% 11.9% 15.5% 26.0%



Financials 81.8% 6.4% 5.3% 6.5% 12.9%

Health Care 79.9% 4.0% 7.8% 8.3% 12.3%

Utilities 93.6% 0.2% 1.1% 5.2% 5.3%


S&P 500 68.0% 6.0% 7.8% 18.2% 24.2%

Source: Bloomberg, Company data, Morgan Stanley Research

Exhibit 70

In Europe, Energy, Materials, Technology and Staples have the greatest sales exposure to EM

% of Total Sales from:

Developed Europe US Other EM

Energy 16.9 22.9 6.0 54.3

Materials 33.7 18.8 4.7 42.8

Information Technology 36.2 21.4 6.9 35.6

Consumer Staples 49.0 14.8 1.7 34.5

Consumer Discretionary 45.1 22.0 2.4 30.6

Industrials 49.0 17.5 4.2 29.3

Telecommunication Services 65.6 5.8 0.7 27.9

Health Care 35.3 33.3 5.3 26.1

Financials 61.8 15.8 2.3 20.1

Utilities 78.5 5.1 0.1 16.2

Europe 46.6 17.6 3.3 32.6


Exhibit 71

In Japan, Materials, Consumer Discretionary, Technology, Energy and Industrial sectors have the greatest exposure to EM

Sector AxJ (%)Europe

(%) North

America (%) Others

(%)Japan

(%)AxJ +

Others (%)

Materials 15.0 1.4 3.5 11.6 68.6 26.6

Consumer Disc. 12.4 5.5 16.2 9.6 56.4 21.9

Information Tech 17.0 9.2 10.0 4.5 59.3 21.5

Energy 6.8 0.2 0.9 4.7 87.5 11.5

Industrials 7.8 2.4 3.8 3.3 82.6 11.1

Consumer Staples 3.0 0.8 3.8 2.9 89.5 5.9

Health Care 2.8 4.8 9.4 1.8 81.2 4.6

Financials 0.4 0.2 0.1 0.4 98.9 0.9

Telecom 0.0 0.0 0.0 0.0 100.0 0.0

Utilities 0.0 0.0 0.0 0.0 100.0 0.0

Japan 9.0 3.3 7.1 5.3 75.2 14.3


44



Exhibit 72

Regional sector correlations to EMBI+

Correlation of regional sector relative performance to EMBI+

US Europe Japan

Financials -0.44 Financials -0.49 Info Technology -0.23

Industrials -0.37 Materials -0.45 Materials -0.23

Materials -0.33 Industrials -0.23 Industrials -0.22

Energy -0.27 Consumer Discretionary -0.19 Consumer Discretionary -0.18

Consumer Discretionary -0.18 Energy 0.10 Energy -0.13

Info Technology 0.06 Info Technology 0.10 Financials -0.13

Utilities 0.38 Utilities 0.17 Telecom Services 0.29

Telecom Services 0.41 Telecom Services 0.38 Utilities 0.30

Health Care 0.53 Consumer Staples 0.53 Health Care 0.38

Consumer Staples 0.53 Health Care 0.56 Consumer Staples 0.45

Market -0.69 Market -0.69 Market -0.45


Exhibit 73

Morgan Stanley base case GDP forecasts weighted by European company geographical revenue exposure

European

Companies'

Revenue Real GDP Growth (%) Contribution To Revenue-Weighted Global Real GDP Growth (%)

Split % 2013 2014 2015 2011 2012 2013 2014 2015

UK 10.1 1.8 2.5 2.2 0.1 0.0 0.2 0.3 0.2

Europe x UK 36.3 -0.5 0.5 1.1 0.6 -0.2 -0.2 0.2 0.4

US 17.5 1.9 2.6 2.7 0.3 0.5 0.3 0.5 0.5

Asia ex Japan 12.7 6.1 6.0 6.4 0.9 0.8 0.8 0.8 0.9

Australia 1.0 2.6 2.8 2.9 0.0 0.0 0.0 0.0 0.0

Japan 2.3 1.8 1.3 1.1 0.0 0.0 0.0 0.0 0.0

LatAm 9.2 2.7 2.9 3.0 0.4 0.3 0.2 0.3 0.3

CEEMEA 10.9 2.2 3.2 3.6 0.5 0.3 0.2 0.4 0.4

Revenue-Weighted Global GDP Growth

Real 1.7 2.4 2.7 2.8 1.7 1.7 2.4 2.7

Nominal 4.6 5.3 5.6 7.0 5.1 4.6 5.3 5.6

Source: Morgan Stanley Research estimates

45



Europe Equities: Industry and stock exposure to EM

Europe is the most exposed DM region to EM contagion As we show in the above analysis, Europe is the DM region that is likely to be most affected by a sharper than expected slowdown in EM, given it derives a higher proportion of its sales from the region and has historically exhibited a greater correlation to EM debt spreads.

Morgan Stanley GDP forecasts imply 6% EPS growth in 2014… To quantify the possible impact on European EPS from further weakness in EM, we can use our top-down revenue-weighted earnings model. As Exhibit 74 shows, when we weight Morgan Stanley’s current GDP forecasts against the geographical revenue exposure of European companies, we generate a real revenue-weighted global GDP growth number of 2.4%. Based on the historical relationship between this series and actual EPS growth, it implies European EPS will grow by around 6% in 2014.

… but EPS would contract 5-10% in an EM shock … However, if we re-run this model using our EM shock scenario GDP estimates discussed earlier in the report, the 2014 real revenue-weighted global GDP growth number would drop from 2.4% today to 1.4%. Based on the statistical relationship

shown in Exhibit 74, this would imply EPS growth of -3%. However, in reality the EPS decline would likely be sharper than this, as it tends to deteriorate more quickly once the real revenue-weighted global GDP growth series falls to 1.5% or less. It is also worth noting that a reading of 1.4% on this series would be in the bottom 10 of historical observations (back to 1971) and lower than in 2012, when real revenue-weighted global GDP growth was 1.7% and European EPS fell 8%.

… equivalent to a 15-20% downgrade to current estimates. In summary, as an approximate rule of thumb, we believe the EM slowdown scenario discussed in this report would see European EPS contract by 5-10% in 2014, equivalent to a 15-20% downgrade from our current top-down EPS forecast of 10% and consensus bottom-up expectations of 12%.

Sectors with the highest EM exposure To provide more granularity, Exhibit 75 shows European industry groups ranked by sales exposure to EM, using data from our annual Global Exposure Guide, May 2013. We calculate that Energy, Technology, Food & Beverages, Materials, Consumer Durables (Luxury Goods), Autos and Capital Goods have the highest revenue exposure to EM. In contrast, Real Estate, Consumer Services, Diversified Financials, Healthcare Equipment, Media, Retailing, Utilities and Software have relatively low exposure.

Exhibit 74

Base case GDP forecasts imply around 6% EPS growth for Europe in 2014

y = 8.4964x - 14.668

R2 = 0.4158

-60

-40

-20

0

20

40

60

-4 -3 -2 -1 0 1 2 3 4 5 6 7

Revenue-Weighted Real GDP Growth (%)

MS

CI

Eu

rop

e E

PS

Gro

wth

(%

)

Revenue-weighted global GDP growth forecasts:2013e = +1.7%2014e = +2.4%2015e = +2.7%

Implied EPS growth:2013e = -0.1%2014e = +5.7%2015e = +8.5%

Source: World Bank, MSCI, Morgan Stanley Research. Note: Revenue weighted GDP growth based on 6 historical editions of the Global Exposure Guide back to 1997. Pre-1997 we assume the revenue weights developed in line with globalisation trends seen in US over the same period.

Exhibit 75

European Industry Groups with highest sales exposure to EM

0 10 20 30 40 50 60 70

Europe

EnergySemis

Food & BevTech Hardware

MaterialsCons Dur

AutosCap Goods

Household ProdPharma

TelecommsTransport

BanksFood RetailComm Serv

InsuranceSoftware

UtilitiesRetailing

MediaHealth Care

Div FinCons Serv

Real Estate


46



Exhibit 76

Which sectors have high EM sales exposure and correlate strongly to EM debt spreads?

-60

-40

-20

0

20

40

60

0 10 20 30 40 50 60

% of revenues from EM

Se

cto

r co

rre

latio

n t

o E

MB

I+ s

pre

ad

s

SemisLuxury Goods

MaterialsAutosBanks

Cap Goods

Transport

InsuranceDiv Fins

Real Estate

EnergyTech Hardware

Food & Bev

Source: Company data, DataStream, Morgan Stanley Research

Comparing sales exposure and correlation to EM debt spreads It is important to note that not all sectors that generate a high percentage of their sales from EM necessarily have a high degree of price sensitivity to the region and vice versa. For example, the Energy sector sells a lot of its product into EM because that is where oil demand is structurally higher, but EM weakness won’t necessarily hurt oil companies more than other, more cyclical, businesses. Hence in Exhibit 76 we compare sectors’ EM sales exposure and their correlation to EM debt spreads (EMBI+) to allow for a more robust identification of those sectors most at risk from EM weakness. This analysis identifies three groups of sectors:

1. Sectors that have above-average sales exposure to EM and a relatively high correlation to EMBI+ are: Materials, Autos, Capital Goods and Luxury Goods.

2. Sectors that have below-average sales exposure to EM but have a relatively high correlation to EMBI+ are: all Financial sectors and Transport.

3. Sectors that have above-average sales exposure to EM but have a relatively low correlation to EMBI+ are: Energy, Technology and Food & Beverages.

Stocks with high EM sales exposure and strong correlation to EM debt spreads. We replicate this approach at the stock level to highlight companies that generate over 30% of their revenues from EM and that have had a negative correlation to EM debt spreads over the last five years. In addition, we have asked the European analysts in those sectors that our work suggests would be most vulnerable to

EM contagion to identify stocks most at risk. Their responses are detailed below.

Materials Within Materials, the two industry groups most at risk from EM contagion are Mining and Chemicals. In Mining, Menno Sanderse believes that Rio Tinto and Anglo American would see the greatest impact, with EBITDA likely to be around a third lower by the end of 2015 in our EM shock scenario. In Chemicals, Paul Walsh highlights BASF and Lanxess as most vulnerable to EM woes.

Autos Laura Lembke argues that the mass market OEMs in Europe are likely to be most negatively impacted by further EM weakness, including Renault. If we saw a meaningful slowdown in China, she believes BMW and Daimler would also be negatively impacted.

Capital Goods Ben Uglow believes the two stocks that would be worst hit by a significant EM/China slowdown would be ABB and Schneider, with both generating around 40% of revenues from the region.

Consumer Staples Eileen Khoo believes that Unilever and Danone would be most adversely impacted from EM weakness within the Food Producers, while SAB has the greatest EM exposure in Beverages.

Banks Banks are always geared plays on economies and markets. In terms of EM risks for the European sector, Huw van Steenis and team would have most focus on Ukraine, Russia, Turkey, Hungary, Brazil, India and some other parts of SEE. Their base case view is that for the Western European banks, the overall exposures are manageable versus capital and earnings power, but they are alert to headwinds and second order impacts on broader economic growth. The team has Underweight ratings on a number of Western European banks with EM exposures where they believe the market has underestimated these issues (among others), including Standard Chartered and Aberdeen Asset Management.

Putting EU banks exposures in context. Banks have the strongest negative correlation of any sector to EM debt spreads. In part, this is likely to reflect the fact that rising EM debt spreads have tended to occur during periods of weaker equity markets in general and Banks are a high beta sector, but this also speaks to the more fundamental pathways. European banks have around US$4.5tn of cross-border

47



lending into EM on their books. This is very broadly split across regions and by banks.

Which banks are most exposed? Huw van Steenis and team suggest that stocks in their sector that would be most exposed in an EM contagion scenario are HSBC, STAN, RBI, BBVA and Erste. Next most exposed would be KBC, Santander, Soc Gen, Unicredit and Credit Agricole. Exhibit 84 shows those banks with the highest percentage of EM revenues and lending relative to total revenues and lending. In asset management, Aberdeen and Ashmore are the most exposed to EM.

Channels of contagion have been materially reduced in recent years. For those banks with a relatively high revenue exposure to EM, a rising cost of capital in these regions also implies a hit to subsequent loan growth, a significant weakening of earnings and a deterioration in asset quality. Take Turkey, where our team’s expectations for Turkish banks earnings are ~40% lower now than they were 6 months ago, reflecting the gearing in the banks’ profits. This said, our banks team believes the channels of contagion have been materially reduced in the last few years as banks have degeared their funding structures (less reliant on wholesale funding), raised large amounts of capital, sold some weaker entities, and changed operating structures. Policy backstops are also in place (Vienna 2, LTRO, OMT, among others). In many emerging markets, subsidiarisation also means capital and funding are already in the local entity, reducing solvency risks for the parent. They would therefore be most focused on the potential for a direct hit to profits but would remain alert to the indirect effects on eurozone growth, given the sector’s vulnerability to shocks.

How does this compare to 1997? Eurozone banks’ relative exposure to EM (measured by EM claims to domestic GDP) has naturally grown over the period. Countries where exposure is materially higher include Austria, though we would highlight that this has not been a wholly organic process, given M&A activity. Nevertheless, as a result, around 90% of claims are now concentrated in Romania, Czech Republic, Poland and Croatia, although Russia and Ukraine are also present. The Greek and Portuguese banking systems are also more exposed than 1997 – the Greek banks to Turkey and other parts of CEE; the Portuguese banks to Poland and regions of Africa. Spain on the other hand is no more exposed on this measure than in 1997. French banks have increased exposure, but recent retrenchment as a result of regulation and funding squeezes has tempered the growth in exposure, especially in CEE and Asia.

Although EM exposure is higher, there are several key differences. First, the positive side of what our Banks team coined “the Balkanisation of banking markets” is that subsidiaries with ringfenced capital and funding in emerging markets reduce the intensity of the transmission mechanism of bank stress to and from a subsidiary. The vast majority of subsidiaries of European banks in Latin America and Asia are set up like this – not least as both regions learned the lessons of past banking crises not to be too reliant on wholesale funding and high mismatches. In Emerging Europe, subsidiaries are prevalent too, as banks acquired existing entities; however the use of cross-border/parent funding was more prevalent. European banks are a long way through deleveraging and de-gearing, although by no means finished. Eurozone banks have shrunk their holdings of cross-border claims by 40% or US$8tn in the last four years to US$10tn. This splits roughly as half cross-border in the eurozone, a quarter claims on the US and a quarter claims on emerging markets, Asia, ROW. With our Asian colleagues, we wrote extensively in 2011 about examples such as French banks shrinking their Asian and Russian exposures when dollar finance became very tight in 201111. As a result, we think the transmission mechanism for wholesale/cross-border banking is also much weaker than 1997 for Asia.

Exhibit 77

European banks exposure to EM is at a record high

0.0

1.0

2.0

3.0

4.0

5.0

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

Co

nsol

ida

ted

EM

fore

ign

clai

ms

of E

urop

ean

ba

nks

LatAm

Emerging Europe

Asia Pacific (ex-Japan)

Africa and Middle East

Source: BIS, Morgan Stanley Research

11

see EU Bank Deleveraging & Asian Trade Finance May

1, 2012

https://ny.matrix.ms.com/eqr/article/webapp/2bb6e16f-0ef1-43fa-86f6-d0105df6767c?ch=rpint

48



Exhibit 78

Miners’ relative performance vs EM debt spreads

80

90

100

110

120

130

140

150

160

170

Feb-11 Feb-12 Feb-13 Feb-14

ST

OX

X E

uro

pe

600

Ba

sic

Re

sou

rce

s R

ela

tive

Pri

ce

Pe

rfo

rman

ce

200

250

300

350

400

450E

MB

I+ S

trip

Sp

rea

d (

bp

) -

INV

ER

TE

D

STOXX Europe 600 Basic Resources

EMBI+ Strip Spread (RHS) - inverted

Source: RIMES, DataStream, Morgan Stanley Research

Exhibit 79

Chemicals’ relative performance vs EM debt spreads

115

120

125

130

135

140

145

Feb-11 Aug-11 Feb-12 Aug-12 Feb-13 Aug-13 Feb-14

ST

OX

X E

uro

pe 6

00 C

hem

ical

s R

ela

tive

Pri

ce P

erfo

rman

ce

200

250

300

350

400

450

EM

BI+

Str

ip S

pre

ad (

bp)

- IN

VE

RT

ED

STOXX Europe 600 Chemicals EMBI+ Strip Spread (RHS) - inverted


Exhibit 80

Capital Goods’ relative performance vs EM debt spreads

105

107

109

111

113

115

117

119

121

123

125


MS

CI

Eu

rop

e C

ap

ital G

oo

ds

Re

lativ

e P

rice

Pe

rfo

rma

nce

200

250

300

350

400

450

EM

BI+

Str

ip S

pre

ad (

bp

) -

INV

ER

TE

D

MSCI Europe Capital Goods EMBI+ Strip Spread (RHS) - inverted


Exhibit 81

Autos’ relative performance vs EM debt spreads

100

110

120

130

140

150

160

170


ST

OX

X E

urop

e 60

0 A

uto

mob

iles

& P

arts

Rel

ativ

e P

rice

Per

form

anc

e

200

250

300

350

400

450

EM

BI+

Str

ip S

pre

ad (

bp)

- IN

VE

RT

ED

STOXX Europe 600 Automobiles & Parts EMBI+ Strip Spread (RHS) - inverted


Exhibit 82

Food & Beverages’ relative performance vs EM debt spreads

90

100

110

120

130

140

150


ST

OX

X E

uro

pe

60

0 F

ood

& B

eve

rag

es

Re

lativ

e P

rice

P

erf

orm

anc

e

200

250

300

350

400

450

EM

BI+

Str

ip S

pre

ad

(b

p) -

IN

VE

RT

ED

STOXX Europe 600 Food & Beverages EMBI+ Strip Spread (RHS) - inverted


Exhibit 83

Banks’ relative performance vs EM debt spreads

80

90

100

110

120

130

140


MS

CI

Eu

rop

e B

ank

s R

ela

tive

Pric

e P

erf

orm

an

ce

200

250

300

350

400

450

EM

BI+

Str

ip S

pre

ad

(b

p)

- IN

VE

RT

ED

MSCI Europe Banks EMBI+ Strip Spread (RHS) - inverted


49



Exhibit 84

EM loan and revenue data for European banks most exposed to EM

28%

15%

55%

31%

61%

52%

56%

83%

87%

19%

19%

22%

22%

24%

26%

36%

38%

71%

82%

23%Société

Générale

UniCredit

Crédit Agricole

Santander

KBC

BBVA

Erste

HSBC

Raiffeisen

StandardChartered

Loans

Revenues

Source: Company data, Morgan Stanley Research. Data as of Q4 or Q3/ 1H13 where Q4 results are not available.

Exhibit 85

European banks with highest percentage of revenues from EM

% of 2013e revenues

Emerging Europe of which… EMEA of which… Asia Pacific of which… Latin America of which…

Co. name Country

GICS Industry Group

Emerging Markets

Central and Eastern Europe

ex Russia RussiaMiddle

East Africa China India

Asia Pacific ex Japan

ex China ex India

ex Australasia Brazil

Latin America ex

Brazil

Standard Chartered Bank United Kingdom Banks 90.0 0.0 0.0 13.0 8.0 0.0 10.0 59.0 0.0 0.0

Raiffeisen Bank International Austria Banks 75.0 59.0 16.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

BBVA Spain Banks 59.0 4.9 0.0 0.0 0.0 2.0 0.0 0.0 0.0 52.0

Santander Spain Banks 56.4 2.9 0.0 0.0 0.0 0.0 0.0 0.0 35.3 18.2

Erste Bank Austria Banks 53.0 53.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

HSBC Holdings United Kingdom Banks 51.0 0.0 0.0 5.0 0.0 0.0 2.0 30.0 0.0 14.0

KBC Group NV Belgium Banks 31.6 31.3 0.0 0.0 0.0 0.0 0.0 0.4 0.0 0.0

Societe Generale France Banks 27.4 10.0 4.4 0.0 7.0 0.0 0.0 4.9 0.0 1.0

UniCredit S.p.A. Italy Banks 26.0 23.0 3.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0


50



Exhibit 86

European stocks with 30%+ sales exposure to EM and negative correlation to EM debt spreads

Name Industry Group Country MS Rating Price (LC)

Market Cap

($ mn)

Correlation to EMBI+

Spread (%)

EM Revenue Exposure

(%)ASML HLDG Semiconductors & Semiconductor Equipment Netherlands Equal-Weight / C € 65.52 39,265 -47.6 65.0NOKIA CORP Technology Hardware & Equipment Finland Equal-Weight / I € 5.53 28,427 -34.7 57.0TELENOR Telecommunication Services Norway Overweight / A NOK 134.30 33,688 -51.4 51.9RAIFFEISEN BANK INT'L Banks Austria Equal-Weight / I € 27.19 10,870 -28.7 75.0SAIPEM ORD Energy Italy Equal-Weight / I € 16.78 10,100 -25.1 80.0ASSA ABLOY B Capital Goods Sweden Equal-Weight / I SEK 329.50 17,892 -43.6 50.7ANGLO AMERICAN (GB) Materials United Kingdom Equal-Weight / I £ 15.34 34,396 -27.1 61.6BG GROUP Energy United Kingdom Equal-Weight / I £ 11.18 62,285 -33.3 53.9PORSCHE AUTOMOBIL HLDG V Automobiles & Components Germany - € 75.60 16,115 -29.4 55.0RIO TINTO PLC Materials United Kingdom Equal-Weight / I £ 35.37 80,509 -24.3 68.6GALP ENERGIA SGPS SA-B Energy Portugal Overweight / I € 12.03 12,697 -32.6 53.9SABMILLER Food Beverage & Tobacco United Kingdom Overweight / I £ 28.84 76,083 -22.3 70.4ANTOFAGASTA Materials United Kingdom Underweight / I £ 9.33 14,854 -22.8 66.1RECKITT BENCKISER GROUP Household & Personal Products United Kingdom Equal-Weight / I £ 50.25 60,656 -42.4 41.0HOLCIM Materials Switzerland Equal-Weight / C SFr 69.65 25,698 -24.2 54.9BRITISH AMERICAN TOBACCO Food Beverage & Tobacco United Kingdom Equal-Weight / A £ 31.83 98,837 -19.3 62.0RENAULT Automobiles & Components France Overweight / I € 74.00 29,912 -31.1 45.0JULIUS BAER GROUP Diversified Financials Switzerland Equal-Weight / I SFr 41.34 10,369 -38.0 39.0ANHEUSER-BUSCH INBEV Food Beverage & Tobacco Belgium - € 74.66 163,367 -26.2 49.0OMV AG Energy Austria Underweight / I € 34.27 15,397 -24.0 53.9KERING Consumer Durables & Apparel France NAV / I € 153.75 26,588 -40.7 37.0TULLOW OIL Energy United Kingdom Overweight / I £ 7.81 11,781 -22.8 53.9INDITEX Retailing Spain Equal-Weight / C € 106.15 90,524 -46.1 35.0SWATCH GROUP INH Consumer Durables & Apparel Switzerland - SFr 585.50 34,990 -16.4 56.3YARA INTERNATIONAL Materials Norway Underweight / I NOK 248.10 11,312 -28.8 42.0PHILIPS (KON.) Capital Goods Netherlands Equal-Weight / I € 25.55 32,660 -42.3 35.0SYNGENTA Materials Switzerland Equal-Weight / I SFr 325.90 33,903 -19.5 53.0REPSOL Energy Spain Underweight / I € 18.21 33,262 -17.6 53.9LAFARGE (FRANCE) Materials France Equal-Weight / C € 54.41 21,462 -9.5 58.0PRUDENTIAL Insurance United Kingdom Overweight / I £ 13.72 57,955 -20.1 45.0DEUTSCHE POST Transportation Germany Overweight / I € 26.51 45,907 -32.1 35.0HEIDELBERGCEMENT Materials Germany Equal-Weight / C € 59.04 15,316 -32.3 34.5DAIMLER Automobiles & Components Germany Equal-Weight / I € 67.69 98,473 -24.5 38.0SAFRAN Capital Goods France - € 50.93 29,051 -35.8 31.0ENEL Utilities Italy Overweight / I € 3.77 48,326 -32.4 32.9BUREAU VERITAS SA Commercial & Professional Services France Overweight / I € 20.37 12,259 -13.1 43.0AP MOLLER MAERSK B Transportation Denmark Equal-Weight / I DKK 66000.00 52,778 -12.0 43.0HEINEKEN NV Food Beverage & Tobacco Netherlands - € 49.08 38,588 -6.2 51.0GAS NATURAL SDG Utilities Spain Equal-Weight / I € 18.84 26,064 -25.4 30.9VOLVO B Capital Goods Sweden Underweight / I SEK 98.55 31,798 -13.6 37.5INFINEON TECHNOLOGIES Semiconductors & Semiconductor Equipment Germany Equal-Weight / C € 7.94 12,354 -11.0 39.0SGS Commercial & Professional Services Switzerland Equal-Weight / I SFr 2222.00 19,528 0.0 47.0VODAFONE GROUP Telecommunication Services United Kingdom - £ 2.52 108,689 -13.2 36.5MAPFRE Insurance Spain Equal-Weight / I € 3.05 12,817 -7.5 42.0ADIDAS Consumer Durables & Apparel Germany NAV / I € 84.86 24,462 -8.5 40.0WPP Media United Kingdom Equal-Weight / A £ 13.49 29,959 -15.6 34.5PERNOD RICARD Food Beverage & Tobacco France - € 86.59 31,376 -21.9 31.0ARCELORMITTAL Materials France Underweight / C € 11.90 26,643 -3.7 40.0DEUTSCHE BOERSE Diversified Financials Germany Equal-Weight / I € 59.52 15,702 -7.7 38.0ALCATEL LUCENT Technology Hardware & Equipment France Equal-Weight / I € 3.18 12,245 -10.6 34.0INT'L AIRLINES GROUP Transportation Spain Overweight / A € 5.41 15,068 -11.8 32.0BAYER Pharmaceuticals Biotechnology & Life Sciences Germany Equal-Weight / A € 102.20 115,214 -3.0 35.0BMW STAMM Automobiles & Components Germany Equal-Weight / I € 84.59 74,375 -10.8 32.0BASF Materials Germany Overweight / I € 83.26 103,596 -0.2 33.0

For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures. For important disclosures regarding non-covered companies that are the subject of this screen, please refer to the Disclosure Section, located at the end of this report. Note: Emerging markets are defined here as World ex developed Europe, North America, Japan and Australasia. Data refer to our analysts’ 2013 estimates as at May 2013, based on company information in combination with their estimates where disclosure is not detailed enough. Source: Company data, DataStream, Morgan Stanley Research

51



US Equities: Industry and stock exposure to EM Equities

While we have generally been a bit dismissive of EM contagion on US earnings, it is clear that a large and broad-based crisis would in fact matter. Our complacency to date has stemmed from our recent learnings from Europe. All prior crises since the fall of 2011 were meaningful ‘buy the dip’ opportunities for the US equity investor. After all, while temporarily fear grew (i.e. brief price-to earnings multiple contraction) a correction to US earnings never really surfaced. So our complacency on EM was rooted in the fact that we do not see a big earnings correction as the base case. Until some large US company with an experienced management team tells us that its EM exposure is truly impairing growth, we just don't see a big correction. After all, the US equity market really never goes down 10% or more unless fear of an earnings recession is palpable.

While quality EM-exposure data are hard to come by, given varied disclosure by corporates, our best guess is that around 18% of US revenue is derived from the EM (including China). That number could be higher because corporate disclosures have an ‘Asia’ category for source of revenues, which includes Japan. If added to the baseline number, that could take corporate revenues coming from EM closer to 22-24%. On the margin, US healthcare, US lending patterns in housing and non-residential, retail, and chemicals are more insulated from an EM crisis than industrials, select technology and consumer staples.

Within industrials, the sub-sectors of metals, mining and machinery would be most affected, owing to their exposure to EM. Similarly, communication equipment in tech and select staples (depending on levels of exposure) would be at risk too. On the other hand, beverages and tobacco stocks would

likely show more resilience given their products should display a lower elasticity of demand. At the other end of the ContagEM risk spectrum, big data analytics and medical distribution names should be unaffected by changes in EM.

An unusual fact about the US stock market is an incredibly low level of dispersion in terms of valuation relative to history, with only defensive stocks slightly more expensive. Changes in the stock market are thus mostly about the overall level of the market rather than a normalization of valuations or any vulnerability that stems from a valuation misalignment. Should an EM shock materialize, sectors and stocks are likely to behave in line with their EM and domestic exposures.

Exhibit 87





Energy 55.3% 2.2% 7.1% 35.4% 37.7%

Materials 52.7% 9.1% 16.2% 22.0% 31.1%

Industrials 62.1% 10.5% 11.9% 15.5% 26.0%



Financials 81.8% 6.4% 5.3% 6.5% 12.9%

Health Care 79.9% 4.0% 7.8% 8.3% 12.3%

Utilities 93.6% 0.2% 1.1% 5.2% 5.3%


S&P 500 68.0% 6.0% 7.8% 18.2% 24.2%


52



Exhibit 88

US stocks most negatively correlated to EM debt spreads

Market Cap ($ Mn) 5Yr

Ticker Company Sector Industry 14/02/2014 CorrelationIVZ Invesco Ltd Financials Capital Markets 15,231 -0.50LUK Leucadia National Corp Financials Diversified Financial Services 10,254 -0.45HOT Starwood Hotels & Resorts Worldwide Inc Consumer Discretionary Hotels, Restaurants & Leisure 15,087 -0.45BEN Franklin Resources Inc Financials Capital Markets 33,315 -0.44MET Metlife Inc Financials Insurance 56,538 -0.43HIG Hartford Financial Services Group Inc Financials Insurance 15,716 -0.42AFL Aflac Inc Financials Insurance 29,003 -0.42CBS CBS Corp Consumer Discretionary Media 38,552 -0.42HST Host Hotels & Resorts Inc Financials Real Estate Investment Trusts (REITs) 14,362 -0.42AMG Affiliated Managers Group Inc Financials Capital Markets 10,097 -0.41RCL Royal Caribbean Cruises Ltd Consumer Discretionary Hotels, Restaurants & Leisure 11,494 -0.41MGM MGM Resorts International Consumer Discretionary Hotels, Restaurants & Leisure 12,752 -0.40PRU Prudential Financial Inc Financials Insurance 39,350 -0.40PLD Prologis Inc Financials Real Estate Investment Trusts (REITs) 20,286 -0.40FLS Flowserve Corp Industrials Machinery 10,661 -0.40DOW Dow Chemical Co Materials Chemicals 56,791 -0.40AA Alcoa Inc Materials Metals & Mining 12,253 -0.39LVS Las Vegas Sands Corp Consumer Discretionary Hotels, Restaurants & Leisure 65,613 -0.39SDRL Seadrill Ltd Energy Energy Equipment & Services 16,831 -0.39NOV National Oilwell Varco Inc Energy Energy Equipment & Services 32,748 -0.39BAC Bank Of America Corp Financials Diversified Financial Services 176,883 -0.37FLR Fluor Corp Industrials Construction & Engineering 13,014 -0.37FCX Freeport-McMoran Copper & Gold Inc Materials Metals & Mining 35,038 -0.37PCAR Paccar Inc Industrials Machinery 21,804 -0.37PXD Pioneer Natural Resources Co Energy Oil, Gas & Consumable Fuels 27,234 -0.36LNC Lincoln National Corp Financials Insurance 12,902 -0.36IP International Paper Co Materials Paper & Forest Products 21,817 -0.36PFG Principal Financial Group Inc Financials Insurance 13,163 -0.36C Citigroup Inc Financials Diversified Financial Services 149,996 -0.36HTZ Hertz Global Holdings Inc Industrials Road & Rail 11,539 -0.35AMP Ameriprise Financial Inc Financials Capital Markets 20,572 -0.35APA Apache Corp Energy Oil, Gas & Consumable Fuels 33,022 -0.35GE General Electric Co Industrials Industrial Conglomerates 260,421 -0.35WYNN Wynn Resorts Ltd Consumer Discretionary Hotels, Restaurants & Leisure 22,449 -0.34KSU Kansas City Southern Industrials Road & Rail 10,579 -0.34STT State Street Corp Financials Capital Markets 30,208 -0.34CMI Cummins Inc Industrials Machinery 26,628 -0.34JPM JP Morgan Chase & Co Financials Diversified Financial Services 218,569 -0.34AES AES Corp Utilities Independent Power Producers & Energy Traders 10,562 -0.34CLR Continental Resources Inc Energy Oil, Gas & Consumable Fuels 20,850 -0.34STI Suntrust Banks Inc Financials Commercial Banks 20,255 -0.34WY Weyerhaeuser Co Financials Real Estate Investment Trusts (REITs) 17,769 -0.33CNA CNA Financial Corp Financials Insurance 11,311 -0.33HON Honeywell International Inc Industrials Aerospace & Defense 74,187 -0.33SCCO Southern Copper Corp Materials Metals & Mining 26,997 -0.33ETN Eaton Corporation Plc Industrials Electrical Equipment 34,506 -0.33PH Parker Hannifin Corp Industrials Machinery 17,575 -0.33MAR Marriott International Inc Consumer Discretionary Hotels, Restaurants & Leisure 15,466 -0.32TROW T. Rowe Price Group Inc Financials Capital Markets 21,196 -0.32FOXA Twenty-first Century Fox Inc Consumer Discretionary Media 73,757 -0.32BK Bank Of New York Mellon Corp Financials Capital Markets 36,312 -0.32JCI Johnson Controls Inc Consumer Discretionary Auto Components 32,537 -0.32For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures. For important disclosures regarding non-covered companies that are the subject of this screen, please refer to the Disclosure Section, located at the end of this report. Source: Bloomberg, IBES, Rimes, Morgan Stanley Research

53



Japan Equities: Industry and stock exposure to EM

Exhibit 89 charts industry level data for revenue exposure to EM (taken as the combined total of Asia ex Japan and other non EU and North America revenue). We find that Semiconductors, Semi Equipment & Components, Materials and Technology Hardware all have more than 20% revenue exposure to EM. At the other end of the spectrum Utilities, Insurance, Banks, Telecoms, Media and Real Estate all have negligible direct exposure. There are some caveats in relation to Japanese banks, where loan books do seem to have expanded recently into EM.

Exhibit 90 shows estimated revenue exposure and simple valuation metrics for the 20 Japan stocks that are most exposed to EM, on our calculations. These firms are concentrated in the Semiconductors, Technology Hardware and Capital Goods sectors. However, there are also some consumer-facing firms in the autos and household products industries that have significant revenue exposure.

Exhibit 89

Japan industry group revenue exposure to EM 0% 10% 20% 30% 40% 50%

Semi & Semi EquipAutomobiles & Components

MaterialsTechnology Hardware & Equipment

Consumer Durables & ApparelHousehold & Personal Products

Capital GoodsEnergy

Food Beverage & TobaccoPharmaceuticals, Biotechnology

Commercial & Professional ServicesSoftware & Services

TransportationHealth Care Equipment & Services

Diversified FinancialsRetailing

Food & Staples RetailingConsumer Services

Real EstateMedia

Telecommunication ServicesBanks

InsuranceUtilities

Source: Bloomberg, Rimes, Morgan Stanley Research

Exhibit 90

Top 20 most EM-exposed TOPIX stocks with market cap larger than USD3bn

Company GICS EM Revenue MS Mcap Latest P/E ROE EPS growth

Name Ticker Industry grp Exposure Rating US$ Bn Price (JPY) 2014E 2014E 2014E

JGC 1963.T Capital Goods 76.6% OW 9.1 3663.0 17.1x 12.5% NA

Murata Manufacturing 6981.T Tech Hardware & Equip. 72.6% EW 19.5 9401.0 19.0x 9.6% 11.0%

TDK 6762.T Tech Hardware & Equip. 64.9% EW 5.4 4355.0 20.3x 4.0% 6.1%

Rohm 6963.T Semiconductors & Equip. 64.7% OW 5.4 5110 20.5x 3.8% 0.3%

Isuzu Motors 7202.T Auto & Components 64.2% UW 10.1 607.0 8.8x 15.1% 4.0%

Yamaha Motor 7272.T Auto & Components 61.0% OW 5.1 1476.0 9.3x 14.0% 26.3%

Suzuki Motor 7269.T Auto & Components 59.6% UW 16.1 2689.0 12.3x 8.8% 11.2%

Hirose Electric 6806.T Tech Hardware & Equip. 56.2% EW 4.8 14250.0 21.7x 7.9% 3.5%

Sysmex 6869.T HC Equip. & Srvcs 55.1% EW 5.9 5850 22.7x 15.9% 14.0%

HOYA 7741.T Tech Hardware & Equip. 53.2% OW 12.6 2961.0 17.9x 11.7% 6.7%

Nidec 6594.T Capital Goods 52.6% OW 16.0 12130.0 18.7x 13.3% 16.0%

Seiko Epson 6724.T Tech Hardware & Equip. 52.3% UW 5.2 2961.0 11.2x 12.7% -17.7%

Unicharm 8113.T HPP 52.2% EW 10.3 5645.0 24.8x 10.1% 38.5%

Fanuc 6954.T Capital Goods 50.5% EW 33.0 17175.0 25.2x 10.1% 11.4%

Sharp 6753.T Cons.Durables & Apparel 48.7% EW 5.2 317.0 9.6x 18.8% 43.8%

Hitachi Construction Machinery 6305.T Capital Goods 42.5% EW 4.0 1935.0 8.9x 10.5% 20.0%

Hino Motors 7205.T Capital Goods 41.4% UW 8.2 1456.0 10.7x 18.8% 0.3%

Komatsu 6301.T Capital Goods 39.2% OW 20.0 2131.0 9.1x 14.5% 16.2%

Nippon Steel & Sumitomo Metal 5401.T Materials 36.3% OW 20.9 295.0 7.0x 12.0% 12.9%

SMC 6273.T Capital Goods 36.1% OW 16.9 25145.0 17.9x 11.0% 9.6%For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures. For important disclosures regarding non-covered companies that are the subject of this screen, please refer to the Disclosure Section, located at the end of this report. Source: Bloomberg, IBES, Rimes, Morgan Stanley Research

54



APxJ and EM Equities: Varying exposure to EM

For EM, we have revisited our earnings model to calculate the impact of the deviation in GDP growth in the EM shock scenario outlined by our economists. This exercise suggests an EPS outcome in the range of US$65 to US$70 for 2014 versus our current base case of US$95. The lower end of this range is equal to the EPS forecast in our current bear case scenario. It would represent a fall in EPS of 25% YoY versus our current base case of 10% growth. At US$65 of 2014 EPS, MSCI EM would be valued at a forward P/E of around 14.6x.

For Japan, a similar exercise suggests considerably less impact on EPS, so long as the Yen eventually regains a weakening trend towards our current base case year end target of Yen 109. Were the Yen to end calendar year 2014 at the appreciated level of Yen 90 / US$ identified by our FX team earlier in this report as a short-term target in an EM shock, in conjunction with weaker Global PMIs and Japan economy watchers index, then an outcome for 2014 calendar year EPS of around Yen 45-50 (down at the low end by 38% versus 2013) might occur. This compares with our base case assumption of 18% YoY growth and shows the high degree of Japan earnings sensitivity to the Yen rather than to EM demand directly.

Though our primary goal in this note is to explore channels of contagion into the US, Europe and Japan, it is worth also paying attention to the divergence of exposure that our country and sector coverage universe within APxJ and emerging markets has to EM. This includes both exposure to domestic growth, where the country itself is within the MSCI EM universe, plus exposure to other EMs.

Exhibit 91 provides granular detail on this topic. Clearly and unsurprisingly, this analysis suggests that EM and APxJ are more exposed to EM than are Europe, the US or Japan – although there are important variations in the degree of exposure.

Variations in exposure among EMs

The most EM exposed countries are Indonesia, Thailand and Malaysia, all with over 90% of listed equities revenues derived from EM. These are followed by China, Chile, Brazil, Poland and Australia. At the other end of the spectrum, there are only a handful of countries with less than 60% listed equities revenue exposure: Singapore, Taiwan and Russia. (For Russia, it is difficult to disaggregate revenue exposure for the large commodity exporters in the index, and we have somewhat arbitrarily assigned revenues to DM for this group purely on the basis that DM countries’ aggregate GDP is larger than EM).

In terms of what is in the price, we find that almost all major APxJ / EM countries are trading at discounts to their 10-year average P/B multiple. This reflects investors’ ongoing concerns on both macro factors (GDP growth trends, leverage/ funding issues) and micro factors (earnings growth and ROE trends) within EM. However, the chart shows there is no simple valuation relationship between revenue exposure to EM and discount to long-run average valuation. Brazil and China – two countries with relatively high EM revenue exposure – are indeed trading at more than 30% discounts to long-run valuations. Yet, the three highest EM revenue exposure countries – Thailand, Malaysia, Indonesia – are all within 10% of historical P/B averages (Malaysia is at a small premium).12

Exhibit 91

EM/APxJ country revenue exposure to EM

0%

20%

40%

60%

80%

100%

Indo

nes

ia

Th

aila

nd

Mal

ays

ia

Ch

ina

Ch

ile

Bra

zil

Pol

an

d

Au

stra

lia

Me

xico

Ho

ng

Kon

g

Ko

rea

So

uth

Afr

ica

Ind

ia

Hu

ngar

y

Co

lom

bia

Tur

key

Sin

gap

ore

Ta

iwa

n

Ru

ssia


Exhibit 92

EM/APxJ countries’ P/B relative valuation to 10-year average vs. Revenue exposure to EM

Indonesia

Thailand

Malaysia

China

Chile

Brazil

Poland

Australia

Mexico

Hong Kong

Korea

South Africa

India

Hungary

ColombiaTurkey

Singapore

Taiwan

(60%)

(50%)

(40%)

(30%)

(20%)

(10%)

0%

10%

40% 50% 60% 70% 80% 90% 100%

Revenue exposure to EM

P/B

val

ua

tion

vs.

10-

yr a

vera

ge


12 For details of Morgan Stanley Asia/ EM equity strategy team’s latest country recommendation hierarchy see Asia/GEMs Strategy: Stay UW EM / APxJ equities vs DM equities: Upgrade Indonesia to EW, Taiwan to OW; Downgrade HK to EW dated 28h January by Jonathan Garner and team.

55



An oil price decline consequent on an EM GDP growth shortfall would have an offsetting positive impact on some markets

In a scenario of a significant growth shortfall in China and EM versus our base case, it is likely that demand for commodities would weaken. If we consider oil only, Exhibit 93 indicates an offsetting positive impact for growth in Korea, Taiwan, India and South Africa, which are major oil importers. Japan would also be a moderate beneficiary. In contrast, although Russia and Mexico have relatively low exposure to EM growth compared with peers, they would be losers in a lower oil price scenario.

There are also important industry level divergences in the degree of exposure to EM of the combined APxJ and EM universe, shown in Exhibit 94. Industries with more than 90% of revenue derived from EM are: Real Estate, Commercial & Professional Services, Insurance, Telecoms, Utilities, Food & Staples Retailing, Healthcare Equipment & Services, Banks and Retailing. At the other end of the spectrum, industries with less than 60% revenue exposure to EM are: Transportation, Consumer Durables & Apparel, Pharma & Bio Life Sciences, Technology Hardware & Equipment, Semiconductors & Semi Equipment, and Software & Services.

If we again look at what is in the price, we also find the lack of a clear relationship between valuations (discount or premium of P/B to own 10-year average) and revenue exposure to EM.

That said, it is possible to demonstrate that a market cap-weighted index tracking the performance of the six most exposed industries relative to the six least exposed industries shows the former significantly outperforming the latter over the past 18 months, when EM GDP growth has been weakening. That suggests that investors have been concerned for some time – and have been pricing in – a slowing EM growth environment.13

13 For details of the Morgan Stanley Asia / EM equity strategy team’s latest industry recommendation hierarchy, see Asia/GEMs Strategy: Industry Quant Model: Upgrade Semiconductors to OW & Materials to EW dated 20th February by Jonathan Garner and team.

Exhibit 93

Net crude oil balance as % of GDP

-10%

-5%

0%

5%

10%

15%

20%

Kor

ea

Tai

wan

Ind

ia

Sou

th A

fric

a

Hon

g K

ong

EU

Tur

key

Japa

n

Ch

ina

Indo

nesi

a

US

Aus

tra

lia

Bra

zil

Mal

aysi

a

Mex

ico

Rus

sia

Source: BP Statistical Review 2013, Morgan Stanley Research

Exhibit 94

EM industry group revenue exposure to EM 0% 20% 40% 60% 80% 100%

Real EstateComml & Prof Svc

InsuranceTelecom Svc

UtilitiesFood & Staples RetlH Care Equip & Svc

BanksRetailing

MediaHouse & Pers Prod

Capital GoodsDivers Financ

MaterialsFood Bev & Tobacco

Consumer SvcAuto & Components

EnergyTransportation

Cons Dur & ApparelPharm Bio&Life SciTech Hard & EquipSemi & Semi Equip

Software & Services Source: Bloomberg, Rimes, Morgan Stanley Research

Exhibit 95

EM/APxJ industries’ P/B relative valuation to 10-year average vs. Revenue exposure to EM

Energy

MaterialsCapital Goods

Comml & Prof Svc

Transportation

Auto & Components

Cons Dur & Apparel

Consumer Svc

Media

Retailing

Food & Staples Retl

Food Bev & Tobacco

House & Pers Prod

H Care Equip & Svc

Pharm Bio&Life Sci

Banks

Divers Financ

Insurance

Real Estate

Tech Hard & Equip

Semi & Semi Equip

Telecom Svc

Utilities

(70%)

(50%)

(30%)

(10%)

10%

30%

50%

70%

40% 50% 60% 70% 80% 90% 100%

Revenue exposure to EM

P/B

va

luat

ion

vs.

10-

yr a

vera

ge

Source: Bloomberg, MSCI, Rimes, Morgan Stanley Research

56



APxJ / EM stocks most exposed to DM

Exhibit 97 shows revenue exposure and simple valuation information for the 20 stocks in our APxJ / EM coverage universe with most exposure to DM (i.e. least exposed to EM demand). The most heavily represented group are Indian software names, followed by selected Technology Hardware and Healthcare, as well as certain niche Materials names with exposure to the paper and platinum industries.

Exhibit 96

EM: Six most EM-exposed industries relative to six least EM-exposed industries (total return in US$)

80

85

90

95

100

105

110

115

120

Jan-

10

Apr

-10

Jul-1

0

Oct

-10

Jan-

11

Apr

-11

Jul-1

1

Oct

-11

Jan-

12

Apr

-12

Jul-1

2

Oct

-12

Jan-

13

Apr

-13

Jul-1

3

Oct

-13

Jan-

14

Source: Bloomberg, MSCI, Rimes, Morgan Stanley Research

Exhibit 97

Top 20 most DM-exposed stocks in EM/APxJ universe

Company Name Ticker GICS Industry Group EM Revenue

ExposureMS

Rating Price Price Curr

Mcap US$ Bn

P/E 2014E

ROE 2014E

EPS Growth 2014E

Infosys Limited INFY.NS Software & Services 85.3% OW 3,824.9 INR 35.4 17.2x 22.8% 22.5%

Tata Consultancy Services TCS.NS Software & Services 82.6% OW 2,275.8 INR 72.1 21.1x 33.2% 26.9%

HCL Technologies HCLT.NS Software & Services 80.5% OW 1,575.6 INR 18.0 17.4x 29.3% 16.2%

Wipro Ltd. WIPR.NS Software & Services 79.3% OW 597.3 INR 23.7 16.6x 22.8% 20.8%

Powertech Technology 6239.TW Semiconductors & Semiconductor Equipment 76.6% EW 42.2 TWD 1.1 10.3x 7.2% 30.7%

Northam Platinum Limited NHMJ.J Materials 75.7% EW 4,222.0 ZAc 1.5 140.1x 1.1% NM

Sappi - Materials 75.3% N/A 3,444.0 ZAc N/A N/A N/A N/A

TPK Holding 3673.TW Technology Hardware & Equipment 74.2% UW 177.0 TWD 1.9 10.9x 12.3% -8.6%

JBS S.A. JBSS3.SA Food Beverage & Tobacco 73.9% EW 7.5 BRL 9.1 10.2x 8.9% -43.5%

Steinhoff International Holdings Ltd. SHFJ.J Consumer Durables & Apparel 73.6% EW 5,190.0 ZAc 11.2 11.1x 15.9% 11.3%

TSMC 2330.TW Semiconductors & Semiconductor Equipment 72.1% EW 108.0 TWD 92.4 13.6x 21.1% 14.1%

Advanced Semi Engineering 2311.TW Semiconductors & Semiconductor Equipment 68.6% EW 30.0 TWD 7.5 13.7x 13.5% 6.3%

Inventec Co - Technology Hardware & Equipment 68.5% N/A 31.9 TWD N/A N/A N/A N/A

Indo Tambangraya Megah ITMG.JK Energy 67.3% OW 25,400.0 IDR 2.5 9.1x 27.6% 36.6%

Indorama Ventures PCL IVL.BK Materials 65.5% UW 20.8 THB 3.0 24.1x 6.5% 25.5%

ScinoPharm 1789.TW Pharmaceuticals, Biotechnology & Life Sciences 65.4% OW 85.2 TWD 1.8 33.4x 16.1% 20.1%

Orascom Construction Ind - Capital Goods 65.1% N/A 344.8 EGP N/A N/A N/A N/A

Fibria Celulose SA FBR.N Materials 63.9% OW 10.7 USD 6.0 32.0x 2.9% 108.6%

Hon Hai Precision 2317.TW Technology Hardware & Equipment 62.9% EW 83.1 TWD 32.5 9.5x 12.0% 5.1%

Kia Motors 000270.KS Automobiles & Components 60.5% OW 56,000.0 KRW 21.3 6.1x 15.6% 10.1%For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures. For important disclosures regarding non-covered companies that are the subject of this screen, please refer to the Disclosure Section, located at the end of this report. Source: Bloomberg, IBES, Rimes, Morgan Stanley Research

57



DM FX: EM contagion would lift USD and JPY

Hans Redeker

A deflationary shock from EM contagion and a global sell-off would push USD and JPY higher.

After an initial move in USDJPY to 90, we think the BoJ would respond so that USDJPY won’t remain offered for long.

EUR would decline as falling inflation expectations risk undermining EUR-denominated assets.

Capital flows shift in favor of USD.

USD is breaking higher, gaining most against emerging market currencies. The high-beta status of EM currencies means that it is normal to have bigger price swings at times of USD strength, owing to US portfolio and credit exposure in the region. EM private sector leverage – particularly in AXJ – has risen sharply, leaving the region exposed to rising global funding costs. In countries where central banks helped to recycle incoming USD via increasing currency reserves, private sectors are often left with a currency mismatch in their asset/liability position. Most of this private sector FX shortage is in USD.

There are several factors to consider in analyzing why a shortage of USD has developed and how it will move FX markets. Potential US economic outperformance driving the cost of USD funding higher is an important factor, which we have frequently discussed in previous publications. The shift in

global growth patterns – namely the breakdown of the EM investment- and export-driven expansion model and the re-industrialization of the US – not only suggests substantial current account balance shifts, but also a shift in capital demand and supply patterns. The old model implied higher real capital returns in EM relative to the US. Capital flows moved accordingly from the US into EM, supporting EM assets and currencies. Now, as the US re-industrializes, demand for capital in the US will rise, suggesting a shift in the evolution of global real rates. While EM real rates will decline, the US equivalent will increase, in our view.

Exhibit 98 shows the divergence between US banks’ foreign and domestic lending. Starting at the end of the dot-com boom up until recently, US banks’ internal and external lending moved in sync, and the relative credit provided to non-US entities increased steadily. Recently, however, US banks have concentrated increasingly on domestic lending, reducing foreign lending simultaneously. This shift in the relative lending pattern of US banks is consistent with USD strength.

Cross-border capital flow growth has eased, marking a substantial difference to those years before 2007. From 2002 until 2007, the pace of cross-border flows accelerated, only to collapse during the US sub-prime crisis. Leaving aside a minor recovery of flows in 2011, cross-border flows stayed weak within the post-Lehman world.

Exhibit 98

US banks are increasing domestic lending

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Exhibit 99

Cross-border flows have fallen from their peak

-20%

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0%

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90%Foreign Cross Border Claims (% of GDP, RHS)

Change in Foreign Cross Border Claims (% of GDP)


58



When economic activity slows, cross-border flows tend to suffer, but we believe this is deeper than a pure cyclical effect. Cross-border capital flows tend to increase when the country providing the main global reserve currency is willing and able to provide the rest of the world with cheap currency. For more than a decade, US real rates undershot real rates outside the US. US savings fell and its current account moved deeply into the red, creating a large availability of USD. Now, as US real rates are rising relative to real returns elsewhere, the US current account deficit is falling. Hence, the US distributes less USD globally. Should US-based investors reduce their massive foreign asset holdings, USD would move sharply higher.

Falling cross-border capital flows and USD strength go hand in hand. When cross-border flows are strong, investor risk appetite tends to increase. Hence, periods of strong cross-border flows are often linked with asset booms. When cross-border flows decline, markets tend to become risk-selective, paying investors for owning the ‘right’ assets.

Risks to EM from China and the US

These findings have implications for cross-currency trades. Countries with very large foreign funding needs to fund external debt or current account deficits are vulnerable. AUD weakness over the past year was affected by this factor, for instance. Canada, with its large current account swing, could become a future loser in a world of slow cross-border capital flows.

China is switching gears, abandoning its export- and investment-driven growth model and leaving the country with overcapacity. The bullish ‘quasi-China trade’ that benefitted AxJ and many other EM economies has reversed. The same economies that increased their dependency on China’s economic performance have remained dependent on USD capital costs. In the post-Lehman world, the combination of lower USD funding costs and a strongly rebounding Chinese economy supported EM growth and pushed private sector leverage in emerging market economies higher. Now the opposite seems to be happening. China slowing down combined with higher USD funding costs suggests that EM is in a period of marked underperformance. The tension between higher USD funding costs and a slowing Asia does not make the Fed’s job easy. At the last Jackson Hole meeting in late August 2013, representatives of EM countries requested that the US monetary authorities be cautious with the start of tapering, which may have been a factor in the delay in Fed tapering from September until December.

Exhibit 100

MSCI: AxJ versus US equity market performance

600

900

1200

1500

1800

2008 2009 2010 2011 2012 2013 2014

300

400

500

600

700

US, MSCI Index, USD

AxJ, MSCI Local Currency Index (RHS)


While the direct impact of EM contagion on Japan’s economic growth may be moderate, and with the greatest impact likely to be felt by the US, we have to consider second-round effects too. Over recent years, Japanese banks have grown their foreign lending book, keeping an increasing amount of foreign assets currency-unhedged. Moreover, the lending book has been geared towards EM and hedge funds, suggesting that the risk sensitivity of Japan’s bank assets has increased. EM currency and asset volatility could cause banks to reduce their FX risks, leading to a sharp rebound in JPY and putting JPY-denominated assets on the back foot.

EM contagion and consequent asset volatility could lead to a serious USDJPY setback to 90.00. Of course, a sharp JPY rebound is unwanted and could undermine ‘Abenomics’, suggesting that the BoJ may ease in response to JPY strength. Accordingly, USDJPY should not stay offered for long.

EUR caught in the middle

While the split performance between the USD and EM currencies (as well as commodity currencies) is well defined, the implications of the framework above for EUR are less clear. Euro area economies would be hurt most, owing to their large exposure to EM (exports, corporate revenues, bank exposure), but it is not the relative weak performance driving the EUR.

The weak balance sheets of domestic financial institutions suggest home-biased investment behavior, which will make it increasingly difficult to recycle the rising current account surplus into long-term foreign assets. A current account surplus does not necessarily mean a strong currency performance14. Take for instance Taiwan, which runs a current

14 see Follow the Flow, January 30, 2014

https://ny.matrix.ms.com/eqr/article/webapp/5f7a9512-8a0f-11e3-ac8d-0f68393f74dc?ch=rpint

59



account surplus of 10% of GDP, thus exceeding the eurozone’s 2.5% current account surplus by a wide margin. TWD is weak, while EUR is strong. The difference between Taiwan and the eurozone is the balance sheet quality of its financial institutions. In Taiwan, marginal return differentials are sufficient to keep banks recycling funds from Taiwan into long-term foreign assets, keeping TWD offered. In the eurozone, the domestic investment bias of the financial industry keeps EUR supported.

Hence, the bearish EURUSD position requires an asset sell-off to flourish. The eurozone’s disinflation has pushed inflation rates way below the 2% target. So far, inflation expectations have remained stable, but should EM develop severe contagion effects, another deflationary impulse may hit the eurozone. Falling inflation expectations undermining the asset outlook could weaken EUR. The German Constitutional Court expressing concerns about the OMT may have increased the hurdle for the European Central Bank to use quantitative easing. Hence, the eurozone heading closer towards ‘Japanification’ via EM contagion could put EUR under selling pressure via falling asset markets. Given the increased foreign exposure in EUR-denominated assets, EM contagion could lead EURUSD down to 1.18.

There are some important distinctions to be made regarding EUR compared to last year. First, European debt markets have become less attractive for foreign investors. Last year, some eurozone sovereign debt markets offered high yield relative to volatility, attracting Japanese portfolio managers. However, risk-adjusted bond yields are now less favorable for EUR.

Second, EUR received support as European banks reduced foreign assets and currency exposure ahead of year-end to prepare balance sheets for the AQR review. At the same time, the eurozone’s outstanding derivatives position moved sharply higher. Interestingly, according to Bloomberg, peripheral banks bought sovereign bonds aggressively at the start of this year, signaling that AQR-related balance sheet preparation was temporary. If this is the case, the support it offered to EUR/USD at the end of 2013 should fade, and EUR/USD should trade back in line with interest rate differentials, suggesting EUR depreciation, as shown in Exhibit 103.

Exhibit 101

EU banks reduced foreign asset holdings more quickly than domestic holdings …

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ds

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Tho

usan

ds

Domestic Assets External Assets (RHS)

EUR trn

EUR trn


Exhibit 102

… and reduced foreign currency exposure via derivatives

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ions


Exhibit 103

Rates differentials suggest a much lower EURUSD

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Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14

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EUR/USD 1Y1Y Spread (RHS)


60



EM FX: ContagEM would accelerate downward adjustment

James Lord

A sharp deceleration in China’s growth could lead to even more pressure on EM currencies.

It is important to note that EM FX has been adjusting for a while now. The sharp appreciation of real effective exchange rates (REERs) prior to the 1997-98 and 2007-08 declines led to a large REER adjustment in the other direction, but such appreciation was in place prior to May 2012, not today.

Of the stressed currencies, we believe that fundamental deterioration and downward pressure on oil prices could make the ruble one of the weakest performers in the EM FX space.

EM currencies, already under pressure from a variety of sources, would see the pace of their downward adjustment accelerate in the event of an EM shock, in our view. Indeed, compared to market expectations that GDP growth stabilises at around 7-7.5%, this scenario would be a significant negative shock.

Market conditions would likely be highly unstable in this scenario, particularly if the EM slowdown takes the market by surprise. When we look at the experience in 1997/98 and the 2008/09 global financial crisis, we can see that EM currencies, on average, corrected by about 10% in both cases. We think a similar level of disruption could ensue for the broader EM asset class, if not more – although with considerable variation across countries.

EM currencies have been in an adjustment process for some time. In contrast with both the 2007/08 and 1997/98 experiences, EM real effective exchange rates (REERs) have been in an adjustment process for some time, in part because of the slowdown in China’s growth and concerns over long-term growth potential as the economy rebalances.

Indeed, in the months leading up to both the 1997/98 and 2008/09 shocks, REERs in EM were on a strong upward trend and overvalued. The sudden shocks that took hold caused a sudden reversal. Now, EM currencies have been in an adjustment process for a while, and REERs have fallen on average by around 5%. China’s vulnerabilities are on the whole well known.

In some cases, like South Africa, REERs have fallen by far more and are down by some 20% from their peak levels. As

such, it is harder to argue that EM currencies are in general overvalued. Many of those economies with large external imbalances have seen significant adjustments already.

This could suggest that more depressed valuations at present could to some extent offset the clear negative shock from a further deterioration in China’s economy and help to prevent more extreme adjustments.

As such, we estimate that EM currencies would fall by 8-10% or so in real trade-weighted terms over 2Q-3Q. This implies a 10-12% move in nominal trade-weighted terms.

Our colleagues in G10 FX strategy expect EUR/USD to decline to 1.18 and USDJPY to 90 in an EM shock scenario. This outlook suggests that the bulk of the adjustment in EM trade-weighted exchange rates would come against USD rather than other currencies – our calculations suggest that EM currencies on average would see an adjustment of around 15-17% versus USD.

We would expect RUB to feel the greatest impact One of the currencies that we would expect to suffer the most in this scenario is RUB. Although the data we have clearly show that the Russian economy is less vulnerable externally than many other markets (large FX reserves, limited external debt, positive current account balance), this masks to some extent the vulnerability of the currency to a broad global growth slowdown that involves a significant shock to oil prices.

Exhibit 104

China GDP and EM FX versus USD

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China Real GDP (%, y/y) EM vs USD


61



There are several reasons to think that RUB would suffer more than most in this scenario. First, the starting point for Russia’s balance of payments is substantially weaker than it was in 2008/09. The combined current + financial account has turned from +10% to a negative position, thanks to the much diminished current account surplus and persistent capital outflows. With oil prices likely to take a significant tumble, Russia’s BoP and RUB would be under pressure, we think.

Second, valuations could play a significant role too. Russia saw one of the largest REER increases in EM from the start of the EM uptrend in 2003. Meanwhile, it has seen one of the smallest adjustments so far since peak levels.

Third, the Central Bank of Russia is unlikely to spend significant quantities of its reserves to defend the currency. The CBR is on a path to allowing a fully floating exchange rate, and while intervention is likely to be in place, we may not see the same level of reserve depletion in Russia as we saw in 2008/09 (when Russia sold approximately one-third of its reserves).

Exhibit 105

Average EM REER decline may not exceed 10% in an EM shock scenario

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-28 -24 -20 -16 -12 -8 -4 0 4 8 12 16 20 24 28

Av EM REER 1997/98 (peak Apr '97)

AV EM REER 2008/09 (Peak Aug '08)


Exhibit 106

RUB REER adjustment has been limited

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Jan 03 - Peak Peak - Now


Exhibit 107

Russia’s BoP has deteriorated significantly

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62



Global Rates DM Rates: The 1997-98 crisis, and now

Anthony O’Brien, Jesper Rooth, Matthew Hornbach

In an EM shock scenario, government bond yields in the G4 markets (US, Germany, UK, and Japan) would fall dramatically, similar in spirit to how they reacted during the various flight-to-quality episodes in 2008 through 2011.

In a world where the return of capital is paramount to the return on capital, the G4 government bond markets would offer the safest haven – with perhaps the exception of gold.

As a possible guide for how a downturn emanating from EM could affect the DM rates markets, it is worth considering what happened in the 1997/98 crisis.

Economic growth in DM economies actually remained robust as the Asian crisis unfolded during the second half of 1997, supported by strong domestic demand. Despite the healthy growth, core yields rallied throughout this period as interest rate hikes that were previously factored into the curve were taken out. However, this bull flattening turned to steepening as the crisis intensified in the second half of 1998, with the Russian debt moratorium and liquidation of LTCM, and monetary easing was quickly priced in (see Exhibit 108).

Today, given the steepness of yield curves globally, we could see a similar scenario play out in response to an EM crisis. We would expect yield curves to bull-flatten initially as markets revise lower their longer-term growth expectations in the absence of an immediate policy reaction from global central banks. The US Federal Reserve would have to first pause its tapering initiative – for which the bar is quite high – then consider ways of strengthening its rate guidance. With an EM crisis likely to play out much faster than the Fed could react, yield curves would bull-flatten for a while.

Back in 1997-1998, the formation of the single currency in 1999 was actually viewed as supportive for European sovereigns during the crisis. Peripheral spreads versus Bunds spiked wider in September 1998 (see Exhibit 109), but with the European governments pressing on with the single currency, the spread widening proved short lived and convergence soon continued. Danish and Swedish swaps, which were unprotected by the single currency, also blew out during the turmoil in September 1998, but remained wider versus Germany through much of 1999. Short-term

dislocations were also evident in the US market in September 1998, as asset swap spreads richened, spreads between on-the-run and off-the-run Treasuries surged wider, while breakevens collapsed.

European (legacy) asset swap spreads (i.e., government bonds less domestic swaps) were also dislocated during the crisis. While Bund asset swap spreads richened when Russia announced a moratorium as a flight-to-quality asset (see Exhibit 110), Italian swap spreads cheapened by 20bp as a result of unwinding an LTCM position.

Exhibit 108

DM rates traded lower in tandem during crisis; US and German 2s10s steepened sharply in response to the LTCM bailout

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2s10s DE 2s10s US 2s10s JPY

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bp %

Source: Thomson Reuters EcoWin, Bloomberg, Morgan Stanley Research

Exhibit 109

5y5y swaps

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Monetary policy response In the run-up to the 1999 euro formation, European central banks were cutting policy rates in unison in order to converge with those of the Bundesbank. As the Asian crisis started, the Bundesbank actually raised rates by 30bp to 3.3% in October 1997, as domestic inflation was edging higher. Similarly, the Federal Reserve appeared unconcerned about the developments in EM, as it kept a tightening bias for most of the first half of 1998. However, only as a result of fear of a collapse in financial markets resulting from the LTCM crisis did the FOMC actually cut interest rates (the fed funds rate was cut by 75bp between September and November). The Bundesbank and 10 other European central banks also cut interest rates early in December (see Exhibit 111), citing a slowdown in the global economy.

But that was then, and this is now

The economic fundamentals in the US and the eurozone are very different today than in 1997-98. During 1997-98, German real GDP was growing at an average pace of 2.7%, while the US averaged roughly 4%. Government debt as a percentage of GDP was around 45% in the US and 73% in the eurozone, but is closer to 73% in the US and 90% in the eurozone today. Hence, governments had greater fiscal muscle back then, and central banks much more monetary stimulus. Although the EM exports feedback loop to the eurozone is relatively small today (but larger than in 1997-98), the economy is much more fragile and the deflationary effects caused by EM and/or financial contagion are a bigger potential risk for the eurozone today than in the late 1990s.

European sovereign spreads, as of yet, have reacted very little to the downturn in emerging markets in early 2014, while the rally in Bunds and Treasuries has arguably been helped by the closing out of short duration positions. We witnessed some weakness in peripheral spreads in late January, but (similar to 1998) this has been short lived. However, unlike in 1998 – when the formation of the single currency was seen as supportive for peripheral sovereigns – if the situation becomes much more serious, threatening global growth, the limitations of the euro project may be viewed as a weakness.

Although sovereign spreads in the euro area decoupled in 2008, BTP spreads have exhibited low correlation with EM equity markets since 2010 (see Exhibit 112). This suggests that it would not be inconceivable for European sovereign spreads to tighten, even if the EM distress continues, unless there were real signs of it affecting the domestic economies.

Two lessons learnt from 1997/98

The crisis of 1997-98 demonstrates two interesting points, both of which are still relevant today. The first is that it is impossible to know the precise outcome of an EM shock. Who would have predicted that the moratorium in Russia would lead to the liquidation of LTCM? So central banks have to be ever-vigilant.

However, the second point is that the ECB and the Fed are only likely to respond if they believe the economic impact could spread to domestic shores. We saw this in the FOMC’s decision to continue to taper despite the concern with some EM countries earlier this year. In addition, the monetary toolboxes are more limited today, and so may restrict central bank action.

Exhibit 110

European asset swap spreads

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DEM 5y IT 5yb


Exhibit 111

Central bank policy response

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64



Exhibit 112

BTP-Bund EM correlation

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4BTP-Bund spread - EM equities correlation


With this in mind, if an EM shock were considered mild and unlikely to invoke a response from the ECB, we would expect Bund yields to remain low and sovereign spreads to continue to tighten as investors enjoy the latter’s carry/roll.

If, however, any EM crisis signalled a clear risk of recession in the euro area and possible deflation, this could push the ECB towards some sort of monetary action. Depending on the severity, we would expect the yield curve to bull-flatten as interest rate hikes are priced out of the curve and asset swap spreads widen as Bunds are viewed as a safe haven. We see sovereign bond spreads widening initially, but when the linkages and extent of the crisis became clearer, they would probably tighten back.

A more poignant EM crisis would also tighten financial conditions in the US presumably. The Fed has responded to tighter financial conditions in the past by easing policy. A pause in the Fed’s tapering initiative would help the Treasury curve bull-flatten – led by the 5- to 10-year maturities. As such, the yield curve beyond 10-years would bull-steepen. To the extent that the markets perceived easier Fed policy as impotent, a flatter 10s30s yield curve would result eventually.

EM Rates: The downside of EM rates upside

Rashique Rahman, Paolo Batori

We see two primary sources of risk and contagion channels from EM local bonds:

1. A reduction in foreign exposure to EM local bonds and, given an estimated 70% of EM local bond mandates are currency unhedged, the broader financial market dislocations this may cause; and

2. A rise in domestic rate risk premiums, leading to a tightening in domestic financial conditions.

Our base case view is that the trend towards asset-price adjustment in EM is likely to remain in place. Our central argument has been that EM economies are experiencing a macro adjustment, the result of a decline in relative competitiveness and productivity.

Domestic imbalances that need to be rectified – represented by the build-up of private sector and financial leverage, real wage growth and inflation – are much more manifest in a subset of EM countries, namely Brazil, India, Indonesia, South Africa, Turkey as well as Russia and Thailand. They are less in evidence for broader EM.

Financial sector reverberations

To the extent that real rates in EM continue to rise and financial conditions tighten, ongoing asset price adjustment in EM is not predicated solely on the US growth trajectory or, by extension, higher US interest rates. More to the point, the implications of tighter financial conditions in EM is that we may witness adverse knock-on impacts to the financial sector – reverberating through the credit channel – and in the process sustaining the rise in financial asset risk premia over the coming months.

We have seen a strong correlation between the path of USD/EM, EM rate risk premia and EM financial stocks – a proxy for financial conditions.

Eventually a contraction in EM imports may serve to materially improve trade balances and stabilize EM currencies – and with this, local rates – but we remain wary of a further rise in EM financial asset risk premia – and particularly so if a US recovery gathers momentum and leads to a further rise in US dollar funding costs.

65



Global Credit US Credit: Indirect effects would have most impact

Ashley Musfeldt

Indirect effects on US investment grade credit would be most meaningful

The more direct impact on US credit markets would be via EM credits and domestic sectors with high EM sales exposure

Short term, we think CDX indices and Financials would underperform on the first signs of EM weakness

Net supply and safe haven demand are mitigating factors

We think the indirect effects on US investment grade credit would be the most impactful, and transition mechanisms such as a slowdown in US GDP growth, uncertainty surrounding the forward path of rates and higher volatility would clearly be bearish for US investment grade spreads; these are three of the six factors in our US investment grade spread model. Furthermore, if risks in EM were to become more systemic in nature – as we saw in 2011 with Europe and the related issues with the banks in particular – we could see an increase in the risk premium in credit. Over a longer-term horizon, to the extent economic weakness in EM was a drag on US growth, it could impact corporate balance sheets, which have already seen leverage rise for the last year and a half.

The more direct impact on the US credit markets would be via two channels – EM credits and domestic sectors with high EM revenue exposure. US investment grade corporate credit has more USD issuance from EM corporates than other currencies do, but at around US$100bn total (index-eligible), it still represents well under 5% of a market that is over US$3.5tn in size. The bigger impact would likely be from the domestic issuers with the highest revenue exposures to EM. These

would be disproportionately in the Basics and Energy sectors, and more specifically the Metals and Mining sub-sector within Basics. In our view, the Basics sector has more EM risk already priced in, and currently trades 20bps wide to Energy, though in a sharp EM sell-off, both would underperform significantly. TMT could be impacted to a lesser extent, as the Telecom subsector has several EM issuers, and the Technology subsector has revenue exposure to EM as well. In a contagion scenario, Utilities would be the clear winner, in our view, as it is an entirely domestic sector with the least EM revenue exposure.

On a shorter-term basis, we think the CDX indices and Financials would likely underperform at the first hint of EM weakness. In recent years, Financials and CDX in particular have been the most liquid parts of the credit markets, and thus tend to be the first areas investors divest in risk-off markets. In the last several sell-offs (Cyprus last spring, Fed-driven uncertainty last June, EM weakness in January), they have underperformed initially, followed by either a rally if the risk off was a ‘false alarm’ like January, or by a follow-on sell-off in the rest of the market. If we were in a true contagion environment, we think high yield and less liquid names and sectors in investment grade could be slower to sell off, but would eventually underperform more significantly.

We do think there are some mitigating factors in US investment grade corporate credit, including net supply and potential ‘safe haven’ demand. Uncertainty surrounding the forward path of rates and the accompanying volatility could temporarily slow down supply into the USD market, providing a mitigating factor on the technical side – a phenomenon we saw last June. Furthermore, higher quality investment grade credit could benefit from potential ‘safe haven’ flows, particularly if the rates market is volatile. On the fundamental side, a prolonged risk-off event in markets could lead to a renewed period of conservative corporate behavior, delaying the ‘credit-unfriendly’ stage of the cycle, which could be a modest positive offset.

.

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Europe Credit: Pockets of EM exposure

Andrew Sheets

The direct impact of a sharp EM slowdown would be relatively modest

But EM exposed sectors would clearly be affected (37 European issuers derive over half their sales from EM)

EM exposure can look more concentrated at the single-name level

We think the direct effect of a sharper EM slowdown on EU Credit would be less severe than on the equity market (adjusting for their respective volatilities). We see three reasons:

EM revenue exposure within European credit issuers is lower than in the equity market, owing to higher weightings to Banks and Utilities and lower weightings to Industrials, Commodities and Consumer Goods.

EM corporate issuers still use the European markets far less than the USD market as a source of funding.

Poor credit market liquidity may, ironically, work to credit’s advantage. Given the difficulty of selling large bond positions, credit investors may decide to ‘look through’ the temporary slowdown in growth modelled by our economists. Equity investors, enjoying better market liquidity, may be more willing to de-risk.

That said, pockets within European Credit would be directly affected. Issuers in the European Energy, Material, Auto, and Chemical credit sectors derive 40% or more of their revenue from emerging markets. These sectors would unquestionably be affected by downside risks to EM growth, due both to direct revenue exposure and second-order impacts on the global economy. On a more granular level, 37 European issuers within our market currently make over 50% of their revenue from emerging markets. While the mix and risk of this exposure varies greatly, it also implies closer linkages.

In managing the risk of a sharper EM slowdown, we would favour two strategies: By sector, we would avoid global cyclicals such as Energy,

Materials, Autos and Chemicals. Trading tighter than long-term averages and with outsized EM exposure, we think these sectors are priced with relatively little cushion against an EM shock scenario.

Exhibit 113

EM exposure breakdown of EUR IG Credit

IG 28

HY 26

Energy 55

Materials 46

Autos & Auto Parts 41

Chemicals 39

Consumer Staples 32

Industrials 29

Healthcare 26

Telecom 23

Media 22

Consumer Discretionary 13

Utilities 12

EM Exposure (%)

Source: Morgan Stanley Equity Research

In single names, we would avoid credits with high exposure to Brazil and China that trade close to ‘fair value’ on our quantitative factor model. Names with high exposure to less volatile regions, yet which are being priced at a quantitative discount, are more attractive.15

For High Yield, temporary economic weakness should (modestly) increase default risk. Our economists model negative growth in 2014 under an EM shock, a scenario that we believe would drive negative EBITDA growth among high yield (HY) issuers. Negative EBITDA growth, in turn, has historically tended to precede an uptick in default rates.

Good issuer liquidity and the temporary nature of the growth shock should both mean that any rise in default rates is modest. But given our market generally expects default rates to fall in 2014, this outcome would still be uncomfortable. Buying short-dated (2yr or 3yr) CDS, which trade at usually tight levels relative to longer-dated credit protection in the vast majority of European HY names, is a relatively inexpensive hedge for such a temporary slowdown.

In Financials, work by our Banks team suggests that outsized EM exposure is concentrated in a small number of institutions. Seven banks source between 20% and 80% of both loans and revenue from emerging markets, and so would face above-average risk in any EM financial contagion scenario, in our view.

15 See Earnings EMergency? February 28, 2014, for specific

examples.

https://ny.matrix.ms.com/eqr/article/webapp/a59b0688-a2da-11e3-b259-4ba0733baf3e?ch=rpint

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Their exposure can be broken down as follows:

Asia-focused UK Banks: EM accounts for 82% of customer loans for Standard Chartered, and 38% for HSBC

CEE-focused Austrian Banks: Austrian banks are the second most exposed group of banks, given that a core part of their development strategy has been an extension toward Central and Eastern Europe. Raiffeisen has the highest exposure, in our view, with close to three-quarters of loans to EM countries.

LatAm-oriented Spanish Banks: EM accounts for 29% of BBVA’s loan book and 22% of Santander’s (excluding the corporate centre), but a significantly larger share of the banks’ profitability. With EM representing a greater threat to profitability than capital, we are less concerned about this third group from a credit perspective.

Exhibit 114

EM loans and revenues as a percentage of the group for selected European Banks

0%

20%

40%

60%

80%

100%

ST

AN

LN

RB

IAV

HS

BC

ER

ST

BK

BB

VA

SA

NT

AN

UC

GIM

% EM Customer Loans % EM Revenues

Source: Company data, Morgan Stanley Research. Data as of Q4 or Q3/ 1H13 where Q4 results are not available.

EM Credit: China’s deleveraging holds the key

Vanessa Barrett, Viktor Hjort, Paolo Batori

China accounts for 31% of the overall Asian credit market risk

Indirect China exposure would affect EM sovereign credit as well

We would expect sovereign spreads to shift towards our bear case

Dominant presence of China. China corporates have been among the most prolific issuers of external bonds over the past five years. Together with Brazil, the sector has seen in excess of US$100bn in issuance since the end of 2008. We estimate that China now represents over 12% of the EM corporate bond universe, a meaningful portion of dedicated EM investors’ portfolios, and it is 28% of the JP Morgan Asia Credit Index by notional. China accounts for 31% of the overall Asian credit market risk (defined as notional amount*spread*duration). In other words, 31% of all Asian credit performance, positive and negative, comes from Chinese credits.

Another risk to an already challenging outlook. In our view, spreads need to better reflect the risk of higher overall balance sheet leverage, slower macro growth across the larger EM economies, higher cost of funding (both locally and externally) and lastly, tighter credit conditions. The increased exposure of the dedicated investor base to China, as well as the direct impact on EM as a whole, presents a further risk to valuations, in our view.

Indirect China exposure would affect EM sovereign credit as well. With no sovereign dollar denominated debt, the direct impact of China risks would be limited. Nonetheless, we believe that EM sovereign spreads would still be significantly affected through the growth impact of a China slowdown on EM economies. Illiquidity means that investors are often forced to sell some of the larger credits despite good fundamentals, which means that higher quality issuers could be at risk too. Lastly, while most sovereign balance sheets are indeed in much better shape than in the early 2000s, the weakness that would materialize in the corporate sector would feed through to the sovereigns.

In this scenario, we therefore see sovereign spreads shifting towards our bear case. Importantly, we do not believe that the move lower in UST yields would provide any comfort, as the anticipated spread widening would outweigh the move lower in UST yields.

68



Commodities: At risk, but not 2008 redux

Adam Longson, Joel Crane

An EM shock in 2Q14 could join forces with poor seasonal demand to drag oil prices below US$80 before a recovery, with oil averaging US$95/bbl for 2014. EM growth has driven the overwhelming majority of demand growth for oil, so a growth shock to EM would produce a sharp reduction in prices, with only a supply response keeping prices from falling further.

Unlike recent scares, a ContagEM scenario would represent a real physical market impact and likely produce a more sustained impact on prices.

An EM shock and over-supply would likely combine to push iron ore and copper prices lower.

Gold would probably benefit from safe-haven seeking investors and could return to its 2013 average, and possibly even higher.

Mapping a demand shock scenario for commodities

Commodities tend to be later cycle than other asset classes. As physical assets, commodities tend to be less forward-looking. Until physical market and price signals are present, feedback loops are lacking. As a result, each demand shock tends to result in a similar, but lagged price pattern.

1) Late-cycle outperformance. Equities and fixed income quickly discount downside risks to growth, while commodities outperform until demand actually slips.

2) Demand shock drives commodity prices lower. Commodity markets are rarely proactive in responding to a demand shock.

3) Supply responds to lower prices, but with a lag. Typically, prices must fall below marginal cost before supply is curtailed, which helps to stabilize prices. In oil, where a cartel operates, the risk of sustained weakness is lower and the supply response can be swift.

4) Recovery: Demand recovers, but the price recovery depends on the magnitude of inventory overhang and supply response. If demand recovers sharply, prices can return quickly to near prior highs, particularly as supply is slow to respond. In contrast, other asset classes will begin to respond to second derivative improvements in economic trends.

Not a repeat of 2008. Prior cycles offer guidance (especially. the Asian financial crisis), but are not a perfect analogue. Not only is the magnitude of the shock likely to be much smaller than in 2008, commodity fundamentals and the level of commodity prices are less concerning today. Consumer hedging is less pronounced, which exacerbated the up and down moves in 2008 and 2009. A number of commodities are pricing closer to marginal cost (e.g., base metals, grains), which suggests that some supply response is already at work and limits downside risk.

Currency issues are more problematic for EM demand this cycle. Not only does EM represent a larger share of demand today, but EM real purchasing power is falling with currency depreciation, and oil subsidies could be at risk. Moreover, unlike recent scares, a ContagEM scenario would represent a real physical market impact and likely produce a more sustained impact on prices.

Some commodities are more insulated from an EM shock (for example, natural gas and agriculture). EM exposure varies greatly by commodity, as does the USD beta. The commodities with the greatest risk would be the base metals, oil and soft commodities. Grains and natural gas are more insulated, given more domestic (and less cyclical) end markets. For natural gas, the only marginal impact would come through DM contagion and slower US GDP growth. Agriculture runs on a very different cycle than the GDP cycle, and EM grain and sugar demand growth show little correlation with EM GDP.

Exhibit 115

Commodities tend to outperform later in the cycle, but underperform during early stages of recovery (Annualized average monthly total return by cycle phase, Jun ‘72 – Sep. ’13)

14.1%11.0%

-19.1%

15.6%

21.5%18.9%

-18.9%

6.6%

Expansion (Early) Expansion (Late) Recession (Early) Recession (Late)

S&P 500 TR (Equities)

SPGCCI TR (Commodities)

Source: NBER, Bloomberg, Morgan Stanley Economics and Commodity Research

69



Crude oil outlook under ContagEM scenario

In a ContagEM scenario, 2014 oil prices could average below US$95/bbl. From the outlined scenario, the EM-led global demand shock would reduce our base case 2014 global oil demand growth from 1 mmb/d to 400 kb/d. While we believe OPEC can ultimately make up for the lost demand by cutting production without placing significant stress on the cartel, OPEC is unlikely to be nimble enough to stop prices from declining. Moreover, sentiment, the potential for contagion and other EM-related feedback loops would likely drive prices lower than simple math would suggest. We see the most price risk in 2Q14, when seasonally slower demand could be exacerbated by decelerating EM. If the timing coincides, we think oil prices could potentially fall below US$80/bbl before recovering.

OPEC remains the final arbiter on oil prices but tends to be reactive, not proactive. OPEC should ultimately limit the downside risk to global oil prices. However, OPEC’s slow response could allow more near-term downside risk. During the 2008 crisis, OPEC did not schedule an emergency meeting until October, only after oil prices had fallen over US$40/bbl. Moreover, implementation was modest until January 2009, two months after the November meeting. Assuming a similar trajectory, OPEC’s already scheduled June 2014 meeting likely wouldn’t result in lower production until August 2014. Under such a scenario, prices could fail to stabilize until late 3Q14, even with seasonally stronger summer demand.

Continued supply and demand headwinds could keep prices under pressure into 2015. Under the outlined scenario, OPEC may overproduce throughout the seasonally weakest months for oil demand. During this period, the Brent curve would likely be in contango and incentivize storage. While we would expect a rebound in oil prices following OPEC intervention and seasonally stronger demand, until this storage overhang is removed, prices could struggle to recover to pre-crisis levels (as seen in 2009-10). Moreover, our base case assumes supply growth outpaces demand into 2015, putting downward pressure on prices. In a ContagEM scenario, demand headwinds (300 kb/d less than our base case) would likely ensure that OPEC must balance oil markets through 2015, keeping average prices under US$100/bbl. That said, with lower prices, the pace of supply growth should slow.

Other feedback loops could mitigate price declines. Beyond OPEC, we see a number of potential reactions to lower prices. 1) Demand response: Oil demand has been

Exhibit 116

Soft commodities and base metals most exposed to EM demand weakness; natural gas is purely DM (% of end market demand/consumption by region)

0%

20%

40%

60%

80%

100%

Na

tura

l Gas

Co

coa

Pa

llad

ium

Cof

fee

RB

OB

Pla

tinum

Silv

er

Bre

ntH

eatin

g O

ilN

icke

l C

orn

Lea

n H

ogs

Zin

cC

oppe

rLi

ve C

attl

eF

eede

rLe

ad

Alu

min

umW

heat

Su

gar

So

ybe

ans

Gol

dC

otto

n

DM EM (ex China) China Source: Bloomberg, Morgan Stanley Commodity Research; Natural gas benchmarked to US

surprisingly elastic, especially in the DM. 2) Global oil capex and supply growth tend to respond to lower prices. 3) A period of lower prices could bring opportunistic stockpiling in the EM.

Lessons from the 1997-1998 Asian Financial Crisis. If our forecasts play out, 2014 oil demand growth could fall below 400 kb/d, the lowest since the 1998 Asian Financial Crisis. From the 1997 peak to the 1998 trough, oil prices declined 47%, and demand growth slowed from 2.0 mmb/d to just over 300 kb/d. We don’t foresee quite as steep a decline in prices this time. However, crude oil prices saw the largest declines after the crisis spread to developed markets in October 1997, suggesting that contagion could be a key downside catalyst.

EM slowdown could have long-term implications for oil. EM growth has accounted for the overwhelming majority of oil demand growth over the past decade. Beyond growing consumption of refined products, the rapid growth in EM refining capacity and strategic stockpiling (primarily China) has provided additional support to demand for crude oil. A slower EM GDP growth outlook and potentially reduced oil subsidies would therefore limit upside for oil prices, at a minimum, and would remove a key offset to rapid growth in non-OPEC supply. Already we are seeing the appetite wane for new refining capacity in China. Conversely, without high oil prices, the case for conservation and substitution is less compelling.

Historically, lower oil prices have also resulted in lower oil-related capex. While a US$90/bbl price environment would keep many new projects in the black, a lower price environment could limit cash flow and slow the pace of investment and supply growth (especially oil sands and

70



offshore projects). Even the US shale story could slow modestly in such a scenario. Given the limited global oil supply growth projected beyond 2016 and the growing reliance on offshore projects with long lead times, a delay in investment could potentially result in even higher oil prices later in the decade.

Exhibit 117

Brent could average <$95 in a ContagEM scenario (MS Brent average price forecast scenarios, US$/bbl)

98

106

103

98

106

85

89

96 96

108

1Q14 2Q14 3Q14 4Q14 2015Base ContagEM


Exhibit 118

After the 2008 crisis, the bulk of OPEC cuts came in Jan 2009, two months after its emergency meeting (Left axis: Brent price and S&P500 indexed to Jan 2008; right axis: OPEC production, mmb/d)

40

60

80

100

120

140

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep

-08

Nov

-08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep

-09

Nov

-09

28.0

29.0

30.0

31.0

32.0

33.0Brent indexed (LHS)

S&P 500 indexed (LHS)

OPEC (RHS)

Emergency meeting

Source: IEA, Bloomberg, Morgan Stanley Commodity Research

Exhibit 119

EM is the primary driver of oil demand growth (Global oil product demand growth, mmb/d)

1.3

1.0

0.4

0.9

1.2

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4 OECD Non-OECD Total

2014 2015Base BaseContagE ContagE

2013 Source: IEA, Morgan Stanley Commodity Research estimates

Exhibit 120

During the Asian Financial Crisis, prices declined 47%, primarily after spreading to DM (MoM ∆ in Brent prices, %)

-20%

-15%

-10%

-5%

0%

5%

10%

15%Ja

n-9

7

Ma

r-97

May

-97

Jul-

97

Sep

-97

Nov

-97

Jan

-98

Ma

r-98

May

-98

Jul-

98

Sep

-98

Nov

-98

Crisis begins

Crisis spreads to the DM

Russia Defaults

Source: Bloomberg, Morgan Stanley Commodity Research

Exhibit 121

EM growth is critical to long-run oil demand, given higher GDP multipliers (3-year moving average of oil intensity, oil demand growth/GDP

growth)

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

OECD AmericasOECD EUNon-OECDChinaOECD EU 2000-2011 Avg

Source: IEA, BP, IMF, Morgan Stanley Commodity Research

71



Exhibit 122

Supply outages and geopolitics add uncertainty (Global supply outages, mmb/d)

-

0.5

1.0

1.5

2.0

2.5

Jan

-12

Mar

-12

Ma

y-12

Jul-1

2

Sep

-12

No

v-12

Jan

-13

Mar

-13

Ma

y-13

Jul-1

3

Sep

-13

No

v-13

Jan

-14

Mar

-14

Ma

y-14

Jul-1

4

Sep

-14

No

v-14

Libya North Sea ArgentinaYemen Syria CanadaColombia US GoM US AlaskaNigeria Nigeria ChinaUAE South Sudan BrazilIraq Russia Kazakhstan

Estimate


Exhibit 123

Aluminium price vs costs: Example of oversupplied market that can overshoot to the downside

20

40

60

80

100

120

140

160

1999 2001 2003 2005 2007 2009 2011 2013

US

c/lb

500

1,000

1,500

2,000

2,500

3,000

3,500

US

$/t

50th Percentile60th Percentile70th Percentile80th Percentile90th PercentileAluminum Price (LME+Premia)


Metals outlook under ContagEM scenario

In a ContagEM scenario, we think 2014 copper prices could average US$2.60/lb ($5,690/t), iron ore may drop to US$84/t and gold could rise to US$1,450/oz. The material drop in GDP outlined in an EM-led global demand shock would have an adverse effect on industrial production growth rates, in our view the key driver of industrial minerals and raw materials.

Already facing oversupply. In the current environment, oversupply is one of the most pointed risks to metals and bulk materials. Lackluster supply growth (one of the major factors

behind the so-called Commodity Super Cycle) has reversed as miners vastly expand output at a time when demand growth has slowed. The global growth risks proposed in this analysis would result in meaningful increases in market surpluses, and price declines would depend on how quickly producers respond to softening demand conditions.

Back to cost support, and probably lower. Broadly speaking, we would expect metals that are already in oversupply to be most vulnerable (aluminum, nickel, lead, zinc) and to fall materially below cost support levels (usually defined as the 90th percentile on the cash cost curve). Using previous growth shocks, namely the GFC, as a guide, it is clear that investors and commodity trading advisors anticipated the price effects and aggressively pressured metal contracts lower. In this regard, commodities that are currently trading furthest above their cash costs are probably the most vulnerable, namely copper.

For bulk commodities, we would expect prices to behave in similar ways, but to be less vulnerable to a retreat below marginal cash cost due to the relative absence of speculative short-sellers in these markets.

For gold, we think the ContagEM scenario would prompt enhanced levels of safe-haven-seeking behavior and drive prices higher, Judging by the performance of gold so far in 2014 (it has risen ~10% simply against the spectre of lower-than-expected growth in the US and China), we believe gold could easily return to it 2013 average, and possibly materially higher.

Key risks to our analysis

A number of factors that are unknown or difficult to model could mean that we have overstated or understated the potential price impact of a ContagEM scenario.

1) Outlook for EM oil subsidies. Many EM countries have oil subsidies in place that are politically difficult to remove, even under periods of economic stress, but help to support demand.

2) The geopolitical landscape remains highly uncertain in a number of key producing countries. Supply outages have been trending at historically high levels. Libya and Iran are offline with little visibility into any return. Iraq is working to lift production, but faces frequent outages and unrest.

3) The speed of the demand shock and contagion. The pace of demand deceleration will dictate whether OPEC can keep prices in a tighter range.

72



Exhibit 124

Copper price vs costs: Example of a market vulnerable to significant downside

0

50

100

150

200

250

300

350

400

450

1999 2001 2003 2005 2007 2009 2011 2013

US

c/lb

0

2,000

4,000

6,000

8,000

10,000

US

$/t

LME Cash Copper Price50th Percentile60th Percentile70th Percentile80th Percentile90th Percentile


Exhibit 125

Iron Ore price vs costs: Example of a market less likely to overshoot

20

40

60

80

100

120

140

160

180

200

2006 2007 2008 2009 2010 2011 2012 2013 2014

US

$/t

cfr

Ch

ina

20

40

60

80

100

120

140

160

180

200

US

$/t

cfr

Ch

ina

50th Percentile 60th Percentile70th Percentile 80th PercentileSpot Iron Ore , 62% fe CFR China 90th Percentile90th Percentile


Exhibit 126

Gold vs US 5-year tip yield: Linked to risk-aversion

$500

$750

$1,000

$1,250

$1,500

$1,750

$2,000

2007 2008 2009 2010 2011 2012 2013 2014

US

$/oz

-2.5

-1.5

-0.5

0.5

1.5

2.5

3.5

5-ye

ar

TIP

S Y

ield

Gold Price (LHS)

US 5-year TIP, yield %( S)

INVERTED SCALE


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Morgan Stanley Blue Papers

Mobile Payments The Coming Battle for the Wallet January 8, 2014

Japan and South Korea The Yen Tide Does Not Lift All Boats May 30, 2013

Autonomous Cars Self-Driving the New Auto Industry Paradigm November 6, 2013

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Global Asset Managers Great Rotation? Probably Not October 8, 2013

Global Steel Steeling for Oversupply May 23, 2013

Capital Goods: 3D Printing Don’t Believe (All) The Hype September 5, 2013

Natural Gas as a Transportation Fuel Energy Market Wild Card April 16, 2013

MedTech: 3D Printing A Solution for Innovation July 22, 2013

Global Semiconductors Chipping Away at Returns April 15, 2013

Commercial Aviation A Renewed Lease of Life July 22, 2013

Wholesale & Investment Banking Outlook Global Banking Fractures: The Implications April 11, 2013

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Releasing the Pressure from Low Yields Should Insurers Consider Re-risking Investments? March 15, 2013

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MedTech & Services Emerging Markets: Searching for Growth August 6, 2012

Big Subsea Opportunity Deep Dive January 14, 2013

Commercial Aviation Navigating a New Flight Path June 26, 2012

eCommerce Disruption: A Global Theme Transforming Traditional Retail January 6, 2013

Mobile Data Wave Who Dares to Invest, Wins June 13, 2012

China – Robotics Automation for the People December 5, 2012

Global Auto Scenarios 2022 Disruption and Opportunity Starts Now June 5, 2012

Global Emerging Market Banks On Track for Growth November 19, 2012

Tablet Landscape Evolution Window(s) of Opportunity May 31, 2012

Social Gambling Click Here to Play November 14, 2012

Financials: CRE Funding Shift EU Shakes, US Selectively Takes May 25, 2012

Key Secular Themes in IT

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The China Files The Logistics Journey Is Just Beginning April 24, 2012

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Solvency The Long and Winding Road March 23, 2012

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Wholesale & Investment Banking Outlook Decision Time for Wholesale Banks March 23, 2012

Global Gas A Decade of Two Halves

March 14, 2011

Banks Deleveraging and Real Estate Implication of a €400-700bn Financing Gap March 15, 2012

Tablet Demand and Disruption Mobile Users Come of Age February 14, 2011

The China Files China’s Appetite for Protein Turns Global October 25, 2011

The China Files Chinese Economy through 2020 November 8, 2010

The US Healthcare Formula Cost Control and True Innovation June 16, 2011

The China Files Asian Corporates & China’s Megatransition November 8, 2010

Cloud Computing Takes Off Market Set to Boom as Migration Accelerates May 23, 2011

The China Files European Corporates & China’s Megatransition October 29, 2010

China High-Speed Rail On the Economic Fast Track May 15, 2011

Petrochemicals Preparing for a Supercycle October 18, 2010

Asian Inflation Consumers Adjust As Inflation Worsens March 31, 2011

Solvency 2 Quantitative & Strategic Impact, The Tide is Going Out September 22, 2010

Wholesale & Investment Banking Reshaping the Model March 23, 2011

The China Files US Corporates and China’s Megatransition September 20, 2010

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Brazil Infrastructure Paving the Way May 5, 2010

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Additional share prices for stocks mentioned

21st Century Fox 33.06USD ABB 22CHF Advanced Semi Engineering 29.55TWD AES Corp 13.86USD Affiliated Managers Group Inc 187.5USD Aflac nc 64.02USD Alcoa Inc 11.62USD Ameriprise Financial Inc 107.75USD Apache Corp 79.86USD Bank Of America Corp 16.3USD Bank Of New York Mellon Corp 31.87USD CBS Corp 65.95USD Citigroup Inc 47.61USD CNA Financial Corp 41.41USD Continental Resources Inc 118.75USD Cummins Inc 143USD Danone 49.89EUR Eaton Corp Plc 73.47USD Fanuc 17295JPY Fibria Celulose 10.51USD Flowserve Corp 79.4USD Fluor Corp 76.92USD Franklin Resources Inc 52.57USD Freeport‐McMoRan Copper & Gold Inc 32.83USD General Electric Co 25.12USD Hartford Financial Services Group Inc 34.76USD HCL Technologies 1504.65INR Hertz Global Holdings Inc 27.25USD Hino Motors 1444JPY Hirose Electric 14530JPY Hitachi Construction Machinery 1942JPY Hon Hai Precision Ind Co 82.8TWD Honeywell International Inc 93.59USD Host Hotels & Resorts Inc 19.65USD Hoya 3001JPY HSBC 622.6GBp Indo Tambangraya Megah 25400IDR Indorama Ventures 20.5THB Infosys Limited 3798.25INR International Paper Co 47.78USD Inventec Corp. 30.15TWD Invesco 33.35USD Isuzu Motors 603JPY J.P.Morgan Chase & Co. 56.21USD JBS S.A. 7.5BRL JGC 3719JPY Johnson Controls, Inc. 48.61USD Kansas City Southern 94.66USD Kia Motors 55800KRW Komatsu 2149JPY LANXESS 52.76EUR Las Vegas Sands Corp 85.97USD Leucadia National Corp 27.56USD Lincoln National Corp 49.79USD Marriott International Inc 53.29USD Metlife Inc 50.07USD MGM Resorts International 27.6USD Murata Manufacturing 9507JPY National Oilwell Varco Inc 77.02USD Nidec 12230JPY

Nippon Steel & Sumitomo Metal 294JPY Northam Platinum Limited 4110ZAc OCI N.V. 34.87EUR PACCAR Inc 65.08USD Parker Hannifin Corp 119.39USD Pioneer Natural Resources Co 202.49USD Powertech Technology 41.4TWD Principal Financial Group Inc 44.8USD Prologis Inc 40.93USD Prudential Financial Inc 82.99USD PSA Peugeot‐Citroen 12.745EUR Rohm 5240JPY Royal Caribbean Cruises Ltd 51.22USD SABMiller plc 2893GBp Sappi Ltd 3514ZAc Schneider Electric 63.86EUR Scinopharm 83.5TWD Seadrill 36.65USD Seiko Epson 3030JPY Sharp 316JPY SMC 24925JPY Southern Copper Corp 30.35USD Standard Chartered Bank 1252GBp Starwood Hotels & Resorts Worldwide Inc 80.72USD State Street Corp 65.2USD Steinhoff Int'l Holdings 5134ZAc Suntrust 37.21USD Suzuki Motor 2684JPY Sysmex 5920JPY T. Rowe Price Group Inc 79.83USD Tata Consultancy Services 2240.05INR TDK 4285JPY The Dow Chemical Co. 48.44USD TPK Holding 177TWD TSMC 108TWD Unicharm 5724JPY Unilever 23.95GBP Volkswagen 183.2EUR Weyerhaeuser Company 29.28USD Wipro Ltd. 585.9INR Wynn Resorts, Limited 242.88USD Yamaha Motor 1477JPY Aberdeen Asset Management 374GBP RBI 24.2EUR BBVA 9.0EUR Erste Bank 25EUR KBC 45.6EUR Santander 6.5EUR Societe Generale 47.3EUR Unicredit 5.7EUR Credit Agricole 11.46EUR Ashmore 315GBp

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Disclosure Section Morgan Stanley & Co. International plc, authorized by the Prudential Regulatory Authority and regulated by the Financial Conduct Authority and the Prudential Regulatory 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. As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates. For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, 10036 USA. For valuation methodology and risks associated with any price targets referenced in this research report, please contact the Client Support Team as follows: US/Canada +1 800 303-2495; Hong Kong +852 2848-5999; Latin America +1 718 754-5444 (U.S.); London +44 (0)20-7425-8169; Singapore +65 6834-6860; Sydney +61 (0)2-9770-1505; Tokyo +81 (0)3-6836-9000. Alternatively you may contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY 10036 USA.

Analyst Certification The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Chetan Ahya, Paolo Batori, Manoj Pradhan, Graham Secker. Unless otherwise stated, the individuals listed on the cover page of this report are research analysts.

Global Research Conflict Management Policy Morgan Stanley Research has been published in accordance with our conflict management policy, which is available at www.morganstanley.com/institutional/research/conflictpolicies.

Important US Regulatory Disclosures on Subject Companies The following analyst or strategist (or a household member) owns securities (or related derivatives) in a company that he or she covers or recommends in Morgan Stanley Research: Laura Lembke - LANXESS(common or preferred stock). As of January 31, 2014, Morgan Stanley beneficially owned 1% or more of a class of common equity securities of the following companies covered in Morgan Stanley Research: Aberdeen Asset Management, Ashmore Group PLC, BASF, BBVA, BMW, Daimler, Erste Bank, Raiffeisen Bank International, Renault, Schneider Electric, Societe Generale, Standard Chartered Bank, UniCredit S.p.A., Unilever NV, Unilever PLC. Within the last 12 months, Morgan Stanley managed or co-managed a public offering (or 144A offering) of securities of BBVA, BMW, Credit Agricole S.A., Erste Bank, KBC Group NV, Santander, Societe Generale, UniCredit S.p.A., Unilever NV. Within the last 12 months, Morgan Stanley has received compensation for investment banking services from BBVA, BMW, Credit Agricole S.A., Daimler, Erste Bank, HSBC, KBC Group NV, Renault, SABMiller plc, Santander, Schneider Electric, Societe Generale, UniCredit S.p.A., Unilever PLC. In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from ABB, Aberdeen Asset Management, Anglo American Plc, Ashmore Group PLC, BASF, BBVA, BMW, Credit Agricole S.A., Daimler, Danone, Erste Bank, HSBC, KBC Group NV, LANXESS, Raiffeisen Bank International, Renault, Rio Tinto Ltd, SABMiller plc, Santander, Schneider Electric, Societe Generale, Standard Chartered Bank, UniCredit S.p.A., Unilever NV, Unilever PLC. Within the last 12 months, Morgan Stanley has received compensation for products and services other than investment banking services from ABB, Aberdeen Asset Management, Anglo American Plc, Ashmore Group PLC, BASF, BBVA, BMW, Credit Agricole S.A., Erste Bank, HSBC, KBC Group NV, Raiffeisen Bank International, Rio Tinto Ltd, SABMiller plc, Santander, Schneider Electric, Societe Generale, Standard Chartered Bank, UniCredit S.p.A., Unilever NV, Unilever PLC. Within the last 12 months, Morgan Stanley has provided or is providing investment banking services to, or has an investment banking client relationship with, the following company: ABB, Aberdeen Asset Management, Anglo American Plc, Ashmore Group PLC, BASF, BBVA, BMW, Credit Agricole S.A., Daimler, Danone, Erste Bank, HSBC, KBC Group NV, LANXESS, Raiffeisen Bank International, Renault, Rio Tinto Ltd, SABMiller plc, Santander, Schneider Electric, Societe Generale, Standard Chartered Bank, UniCredit S.p.A., Unilever NV, Unilever PLC. Within the last 12 months, Morgan Stanley has either provided or is providing non-investment banking, securities-related services to and/or in the past has entered into an agreement to provide services or has a client relationship with the following company: ABB, Aberdeen Asset Management, Anglo American Plc, Ashmore Group PLC, BASF, BBVA, BMW, Credit Agricole S.A., Daimler, Erste Bank, HSBC, KBC Group NV, LANXESS, Raiffeisen Bank International, Renault, Rio Tinto Ltd, SABMiller plc, Santander, Schneider Electric, Societe Generale, Standard Chartered Bank, UniCredit S.p.A., Unilever NV, Unilever PLC. Morgan Stanley & Co. LLC makes a market in the securities of ABB, BBVA, HSBC, Santander, Unilever NV, Unilever PLC. Morgan Stanley & Co. International plc is a corporate broker to SABMiller plc. The equity research analysts or strategists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues. Morgan Stanley and its affiliates do business that relates to companies/instruments covered in Morgan Stanley Research, including market making, providing liquidity 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. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report. Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions.

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 February 28, 2014) 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.

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Coverage Universe Investment Banking Clients (IBC)

Stock Rating Category Count % of Total Count

% of Total IBC

% of Rating Category

Overweight/Buy 1015 34% 303 37% 30%Equal-weight/Hold 1307 44% 392 48% 30%Not-Rated/Hold 100 3% 24 3% 24%Underweight/Sell 538 18% 90 11% 17%Total 2,960 809 Data include common stock and ADRs currently assigned ratings. Investment Banking Clients are companies from whom Morgan Stanley 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 or MSCI sub-regional index or MSCI AC Asia Pacific ex Japan Index. .

Important Disclosures for Morgan Stanley Smith Barney LLC Customers Important disclosures regarding the relationship between the companies that are the subject of Morgan Stanley Research and Morgan Stanley Smith Barney LLC or Morgan Stanley or any of their affiliates, are available on the Morgan Stanley Wealth Management disclosure website at www.morganstanley.com/online/researchdisclosures. For Morgan Stanley specific disclosures, you may refer to www.morganstanley.com/researchdisclosures. Each Morgan Stanley Equity Research report is reviewed and approved on behalf of Morgan Stanley Smith Barney LLC. This review and approval is conducted by the same person who reviews the Equity Research report on behalf of Morgan Stanley. This could create a conflict of interest.

Other Important Disclosures Morgan Stanley & Co. International PLC and its affiliates have a significant financial interest in the debt securities of Anglo American Plc, BASF, BBVA, BMW, Credit Agricole S.A., Daimler, Danone, Erste Bank, HSBC, LANXESS, Raiffeisen Bank International, Renault, Rio Tinto Ltd, SABMiller plc, Santander, Schneider Electric, Societe Generale, Standard Chartered Bank, UniCredit S.p.A., Unilever NV, Unilever PLC. Morgan Stanley is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Morgan Stanley produces an equity 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 research on the same stock. 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MORGAN STANLEY RESEARCH - L'Agefi Actifs · MORGAN STANLEY RESEARCH March 5, 2014 ContagEM Contributors to this Report The contributors to this report are opining only on their respec