MORGAN STANLEY RESEARCH Global EM Strategy Outlook · Global EM Strategy Outlook Meet the New EM ....

December 3, 2013

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

Global EM Strategy Outlook Meet the New EM EM faces the challenge of regaining a decade of lost competitiveness. Macro adjustment is vital to re-establish the virtuous cycle between DM and EM growth. Although we do not envisage an EM crisis in 2014, several possible implementation risks require more generous valuations. Given the mix of policy constraints, the “new EM” is much more fragmented. Differentiation is key.

As we enter 2014, we recommend a REDUCE stance (sell on strength) in both currencies and credit, and move to HOLD in local rates.

Currencies – FX Weakness to Grab Global Growth We look for a further weakening in EM currencies against USD on the back of: i) Rising USD funding costs; ii) A generally weak export environment accompanied by deteriorating terms of trade for commodity exporters; and iii) A host of domestic risks including inflation challenges, poor internal debt dynamics and election uncertainty, which may present hurdles to several EM economies in implementing much-needed supply-side reform. However, it will not be one story fits all, and we see plenty of scope for differentiation across EMFX, with our most bullish views on KRW, MXN and PLN (see Exhibit 1).

Rates – Going Higher, Going Steeper Higher DM rates, weaker currencies and, selectively, deteriorating fiscal balances are likely to remain headwinds for EM rates in 2014, though subdued inflation is likely to keep the front ends anchored in the more structurally sound countries. Mexican and Russian bonds should outperform on a mixture of reform progress and monetary policy easing. Indonesia should underperform due to weak fundamentals and rate hikes, while Poland’s low yield does not offer enough protection from rising core rates and prospective policy tightening (see Exhibit 2).

Credit – Positioning for Further Spread Widening We believe that sovereign credit is set to face another year of negative returns. Reasons include increasing UST yields, weak EM growth and a need for structural reforms to adjust macro imbalances. The upward pressure on spreads is likely to intensify in early 2Q14 as investor attention shifts from external imbalances to domestic issues, notably the fiscal trajectory and upcoming elections. We maintain a defensive allocation with overweights in Mexico, Poland and Russia. Brazil is our main underweight, and we see its underperformance as one of the key drivers for portfolio returns next year (see Exhibit 3).

Note: See page 25 for asset-level end-year returns.

M O R G A N S T A N L E Y R E S E A R C H GLOBAL EM MACRO STRATEGY TEAM

For research analysts, please see contact list at the back of this material.

Exhibit 1

Outperform: KRW, MXN, PLN Underperform: BRL, IDR, RUB

95

97

99

101

103

105

107

109

111

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

103.8

Source: Bloomberg, Morgan Stanley Research forecasts

Exhibit 2

Outperform: Mexico, Russia Underperform: Indonesia, Poland

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

Feb-13 May-13 Aug-13 Nov-13 Feb-14 May-14 Aug-14 Nov-14

6.7

6.1


Exhibit 3

Outperform: Mexico, Poland, Russia Underperform: Brazil

355

200

250

300

350

400

450

500

550

Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Source: Bloomberg, Morgan Stanley Research forecasts Note: 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.


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December 3, 2013 Global EM Winter Outlook

Table of Contents Global EM Strategy Outlook ............................................................................................................................................... 3

GEM Cross-Asset Compass .............................................................................................................................................. 8

Study #1: Measuring Local Markets’ Vulnerability to QE ................................................................................................... 9

Study #2: Measuring EM Credit Vulnerability to QE Tapering ......................................................................................... 10

Study #3: EM Corporates: Rising Leverage, Rising Risk ................................................................................................. 11

Currencies: More Weakness Ahead ................................................................................................................................ 12 Local Rates: Trading Higher Rates .................................................................................................................................. 13

Sovereign Credit: Preparing for Further Spread Widening .............................................................................................. 14

Corporate Credit: Chasing Quality ................................................................................................................................... 15

Regional Market Views: Latin America ............................................................................................................................ 16

Regional Market Views: CEEMEA ................................................................................................................................... 19 Regional Market Views: Asia Ex-Japan ........................................................................................................................... 22

Morgan Stanley EM Forecasts ......................................................................................................................................... 24

Recommended Reads 2014 Global Macro Outlook: Five Key Transitions 2014 Global Strategy Outlook: Fertile Soils, Rising Divergences

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Global EM Strategy Outlook

Theme #1: Differentiate within ‘the New EM’: Investors used to see the broad EM asset class as a vehicle to gain exposure to cheap FX valuations and strong growth. ‘The new EM’ is much more fragmented and investors should scrutinise this heterogeneous space, differentiating and requiring generous valuations able to compensate for the risks associated with the long-term macro adjustment.

Theme #2: External-to-Domestic Vulnerabilities: EM assets are set to experience further repricing to rebalance the risk/reward profile in 2014. Although we do not envisage a broad EM crisis, the majority of the EM economies have to enter a long and complex macro-adjustment process to regain competitiveness. Indeed, some more stressed idiosyncratic situations (i.e., Ukraine and Venezuela) may add volatility to the EM complex. We believe that investor focus will turn towards domestic vulnerabilities, particularly financial sector and fiscal risks.

Theme #3: Flows – A Glass Half-Full: We see limited evidence of a broad-based exit from EM assets, despite persistent retail-oriented dedicated fund outflows. Institutional investor interest in EM, by all accounts, remains strong. Foreign ownership of local bonds has remained steady. While the near-term outlook seems supportive for fixed income, the picture appears less clear for FX. What’s more, we see risks of a reassessment of the risk-reward in continuing to allocate towards EM, if the EM economies were to delay adjustment towards a sustainable growth trajectory.

EM faces the challenge of regaining a decade of lost competitiveness. A virtuous cycle of steady macro improvement and capital inflows is, we believe, at the cusp of being broken. We believe macro adjustment is vital to re-establish the beneficial links between DM and EM growth; absent decisive policy response, markets are likely to continue to do a measure of the adjusting.

Meet the new EM.

It is characterized by more micro than macro level challenges, rising private sector as opposed to sovereign leverage – and fragmentation between the markets of those economies resilient in the face of rising global rates and a rebalancing China against those that are not.

With the new EM, differentiation is key.

We will get to know the new EM better over the course of 2014. Although we do not envisage an EM crisis in 2014, several possible implementation risks require more-generous valuations, across asset classes.

We expect on average about 3% depreciation in EM currencies versus USD (from expected end-2013 levels), though some markets such as Brazil, Turkey and Russia could fall by 7-10%. In sovereign credit, we anticipate 75bp widening with an additional 30bp in EM corporate credit. Finally, we forecast a 50-75bp rise in 5Y EM local bond yields.

The 2014 Roadmap – The Focus of Markets

1-3m: External-to-domestic spillover: Investors focused mainly on external EM imbalances since the beginning of the market sell-off in May 2013. However, we believe that the attention will soon shift to the possible domestic spillover. Rising real rates, currency weakness and increasing risk premia should cause an adverse balance sheet impact on both the sovereign and private sector (see Exhibit 2).

3-6m: Financial sector and fiscal risks: A weaker economy challenged by increasing cost of funding and fiscal slippage in the context of an election year (see Exhibit 7) may require increasing scrutiny of banking sector contingent liabilities to the sovereign and their ability to cushion the negative impact (see Exhibit 3).

6-12m: Recovery and consolidation: In the second half of the year, as the majority of elections will be behind us, it may be possible to have an increased emphasis on structural reform and supply-side adjustment. In addition, import contraction could improve external accounts and restore EM currency net demand. Repricing and valuation adjustments are set to improve underlying risk/reward.

Should We Worry about (Out)flows?

We see limited evidence of a broad-based rush to the exits from EM assets, despite persistent retail-oriented dedicated fund outflows. Institutional investor interest in EM, by all accounts, remains strong. Foreign ownership of local bonds has remained steady, and our data on third-party EM manager searches are at all-time highs (see No Rush for the Exits, November 26, 2013).

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Exhibit 1 Phase One: A Virtuous Cycle – Broken?

Sovereign balance sheet improvement

Sovereign credit rating upgrades

Central bank intervention to sustain relative competitiveness

Lower perceived macro

vulnerability, still-attractive returns

Terms of trade boost to EM,

abundant capital flows

Low global interest rates, China economic

accession, policy regime shifts

The Virtuous

Cycle

Exhibit 2 Phase Two: External to Domestic Spillovers (1-3m)

Private sector balance sheet deterioration

Financial sector impact, rising loan

impairments

Rise in (real) rates and market risk

premia

Weaker domestic demand offset by

government stimulus

EM currency depreciation especially for

countries with high external funding

needs

G4 Removal of Extraordinary

Monetary Accommodation

External-to-Domestic Spillovers

Exhibit 3 Phase Three: Financial Sector and Fiscal Risks (3-6m)

Source: Morgan Stanley Research


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This suggests that there is underlying technical support for EM fixed income into 1Q14, but judging from the pipeline, less so into 2Q14 as new money mandates moderate. Based on these data, near-term technical support for EM currencies is likely more mixed.

Further out, if investor concerns about the sustainability of EM growth (relative to DM) become more acute, we may see a reassessment of the risk/reward in continuing to allocate towards EM, even among longer-term investors.

With regard to the current cash buffer, EM credit funds hold a below-average 3.9% of their assets in cash, while local rates investors seem to own a slightly healthier 5.7%. This is in line with a seasonal pattern that anticipates inflows in 1Q14; nevertheless, it is worth monitoring how the opposite forces of retail and strategic investors will play out.

Get Ready for Further (Downward) Repricing

Although we do not envisage an EM crisis, the above-described macro challenges and the necessary adjustment process require a continuation of the ongoing re-pricing across EM fixed income and FX. Local rates look more defensive, once the carry is considered, but the risk/reward is not favourable either, in our view. Exhibit 4 2014 EM Expected Returns (Scenario Weighted)

949596979899

100101102103104105

Dec-13 Mar-14 Jun-14 Sep-14 Dec-14Local Bonds (in local currency) FX (with carry)Local Bonds (Unhedged, in USD) Sovereign CreditLocal Bonds (Hedged)

0.7%

-0.9%

-3.6%

1.6%

4.1%

Source: Morgan Stanley Research. Returns are weighed in terms of base/bull/bear using probabilities 60%-20%-20%. Local Bond Hedged returns are calculated by subtracting FX capital gains from Local Bond returns in local currency. We expect sovereign credit to post total returns of -3.6% until end 2014, with a front-loaded negative trajectory in the last part of 1Q14 due to a combined unfavourable move of both US Treasury yields and credit spreads. Local bonds are set to record a 4.1% return in local currency terms, with moderate capital losses offset by interest gains, though this return turns into a reduced gain of 0.7% when expressed in USD terms. We also anticipate moderate positive performance of 1.6% in

FX, entirely driven by the high carry. Overall, we think that the risk/reward of the three asset classes is unattractive.

All this would translate into an unfavourable total return for EM fixed income versus FX, with credit being the underperformer (see Exhibit 4).

Markets are likely to trade sideways for the remainder of 2013 and, possibly, into early 1Q14. We would fade any material market rebound and see it as an opportunity to implement our strategic view, anticipating further valuation adjustment.

As the secondary market liquidity tends to evaporate in periods of volatility and the primary market is set to absorb the seasonal inflows quickly, we advise investors to anticipate their portfolio actions aimed at reducing risk.

We implement the following change in stance:

Currencies from Hold to Reduce

Local rates from Accumulate to Hold

Sovereign credit from Hold to Reduce

Corporate credit from Hold to Reduce

Currencies: FX Weakness to Grab Global Growth

EM countries suffer from a broad array of macro challenges that will likely make further currency adjustment necessary in order to regain competitiveness.

First, higher global funding costs and the tightening of USD liquidity are set to challenge the previously EM-supportive flows. An unfavourable real rates differential could weaken EM FX and require monetary policy actions not entirely justified by the economic cycle.

Second, DM consumption growth remains weak, and China’s growth is likely to keep slowing (and perhaps become less commodity-intensive), testing the old EM growth model based mostly on commodities and export sectors.

Third, to the extent that US growth is increasingly driven by investment, and less by consumption, there will likely be less benefit to EM. Meanwhile, Europe remains under the threat of prolonged stagnation as deflation and low growth are likely to become entrenched in the absence of vigorous action from European policy-makers.

For much of the last 10 years, inflows into EM have been attracted by perceived undervalued exchange rates, as well as high growth prospects and returns on investment. What has changed, now? Labour is more expensive, growth models are being questioned, and in some cases real exchange rates are still rich. In an environment of less abundant global


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capital, structural reforms are needed to make EM an attractive investment destination.

EM is not just vulnerable to a slowdown in foreign inflows. Domestic vulnerabilities are rising too in some cases. Fast credit growth and domestic leverage are worrying features in economies such as Brazil, Turkey and China. Indeed, as our corporate credit analysts have highlighted, it is not just external debt that has risen in EM, but domestic banks have also extended large quantities of credit in some cases, leading to significant increases in total private sector debt relative to GDP.

We are concerned that some EM policy-makers will engage in monetary and/or fiscal stimulus to support economic growth amid a less supportive external environment. This would be the wrong strategy, in our view.

EM countries need to regain internal competitiveness, engaging in reform to boost productivity growth, particularly with demographics taking a less growth-supportive turn in many economies. In addition, the majority of them should regain external competitiveness via controlled FX depreciation, in our view, aiming to achieve the right balance between cheaper FX valuations and manageable inflation trajectories.

Not all EM currencies are vulnerable to the processes outlined above. Some markets do not suffer from obvious domestic or external vulnerabilities, despite significant exposure to foreign capital markets (i.e., Poland and Mexico). Exhibit 5 CPI Differential for F5 and RUB High and Rising

-2

0

2

4

6

8

10

12

14

16

03 04 05 06 07 08 09 10 11 12 13

F5+RUB CPI Differential with USD, EUR

Rest of EM CPI Diffential with USD, EUR

Source: Morgan Stanley Research, Haver Analytics

Furthermore, not all EM economies suffer from competitive challenges. Indeed, inflation is not a generalised problem within EM. Outside of what we designate the ‘Fragile Five’ (South Africa, Turkey, India, Indonesia, Brazil) and Russia as well, pressure on currencies from high inflation looks to be negligible.

We expect continued differentiation in the market based on these themes, and we are overweight PLN, KRW and MXN in particular.

Local Rates: Going Higher, Going Steeper

Several factors inform our view on the direction and shape of EM local yields. First, consistent with the steady rise in core rate market yields in our baseline scenario, we see further widening and steepening in EM local rate curves. Second, our baseline expectation of a further bout of EM currency depreciation suggests that we could see a pass-through of FX volatility to EM local rates (see Exhibit 6). However, this is likely to adversely affect some rate markets more than others, particularly countries perceived as externally vulnerable. Mitigating these two exogenous factors are prospects for domestic growth and inflation moderation, which may anchor the front ends of curves and, in conjunction with core rate and EM currency volatility, magnify the scope for rate curve steepening. Exhibit 6 EMFX Weakness Pass-through to EM Rates

85

89

93

97

101

105

0

50

100

150

200

250

300

Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13EM 10y Risk Premium (bp) USD/EM


In CEEMEA, we believe that Turkey and South Africa have scope to underperform despite the high carry, remaining highly sensitive to bouts of domestic currency volatility. We favour Russia local bonds, given prospects for a peak in inflation into 2H14 and the relative attractiveness of yields. CEE rates, particularly the front ends, are likely to stay anchored by low correlation with US rates and a disinflationary dynamic in the euro area. In the region, Hungary has scope to continue to outperform on valuation grounds.


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In LatAm, we expect increased differentiation between the two largest markets, Mexico and Brazil, keeping in mind that differentiation can only go so far in the context of higher US Treasury yields. While we do not expect Peruvian Soberanos to offer much value next year, Colombia’s local TES could gain from easier monetary policy than currently expected and continued inflows from further opening its local bond market to foreigners.

In Asia, we expect Korea, Taiwan and Thailand to normalise monetary policy and hike rates in 2014. As with broader EM, we expect most Asian bond curves to bear-steepen in 1H14 except Taiwan, where we expect early normalisation of the policy rate by the CBC. In the second half, most markets should flatten along with undertaking rate hikes, especially Korea and Thailand. Although China reform is positive for the medium-term outlook, deleveraging is still a challenge for the near term. We believe that downside risk on the growth front might push the PBOC to ease monetary policy in the second half. In this regard, we expect the curve to flatten in 1H when growth slows and turn to steepening in 2H, driven by policy easing. India and Indonesia are facing the most outflow pressure in AxJ, given their weak fundamentals and current account deficits.

EM Credit – Marrying Macro and Micro Challenges

This asset class is set to underperform in 2014, due to increasing UST yields, weak EM growth and the need for structural reforms to adjust macro imbalances. The upward pressure on spreads is likely to intensify in early 2Q14 as investors’ attention will shift from external imbalances to domestic issues (i.e., fiscal trajectory and elections – see Exhibit 7). We forecast the EM sovereign benchmark at 430 and the EM corporate benchmark at 460 for the end of 2014. Exhibit 7 Elections – The Near-Term Hurdle to Reforms

Date Country TypeApr-2014 Hungary Parliamentary electionsApr-2014 South Africa Parliamentary electionsApr-2014 Thailand Senate electionsApr-2014 Indonesia Parliamentary, senate and local electionsSpring 2014 Turkey Local govt. and municipal electionsMay-2014 South Africa Presidential electionsMay-2014 Lithuania Presidential electionsMay-2014 Colombia Presidential electionsBefore May 31, 2014 India General electionsJun-2014 Israel Presidential electionsJul-2014 Indonesia Presidential electionsAug-2014 Turkey Presidential electionsOct-2014 Brazil Presidential elections


We are strategically bearish for 2014, though material weakness may not surface until later in 1Q14. We have expressed our bearish bias lately by owning a very defensive portfolio (i.e., high-quality credits in the 10Y sector). However, we think it is time to change stance from Hold to Reduce, taking advantage of the possible strength in the coming two months, driven by seasonal inflows in the asset class.

We are overweight Mexico, Russia, Poland and other CEE countries, to a lesser degree. Brazil remains our top underweight with Malaysia and we now add Turkey and South Africa to the list. Although our base case does not contemplate any sovereign default, we cannot rule out a sharp deterioration of the current challenging FX and funding situations in both Venezuela and Ukraine. We are currently equal-weight on both, as carry considerations make timing key, but with a very cautious bias.

Should the deterioration in economic conditions in Venezuela continue or even accelerate, this would likely have spillover impact on the rest of the market, in our view. Potential channels of contagion are related to economic ties, financial linkages and market dynamics. The first two are unlikely to have a significant impact in the absence of a negative tail event, in our view. However, ongoing deterioration could still weigh on the index performance, negatively affecting retail flows to real money investors. Should retail outflows accelerate rapidly, more liquid names with overweight positioning (i.e., Russia, Brazil and Mexico) might underperform in the first stage. However, it is worth highlighting that institutional flows are likely to be more resilient, potentially providing some support to the asset class.

On the corporate sector, we expect investor focus on deteriorating balance sheets and weaker operating environments to keep upward pressure on spreads. While we anticipate an uptick in corporate default rates, absent any severe external shock we do not see a large spike in default rates. We continue to see the best value in the quasi-sovereign and BBB rated corporates. Current valuations prompt us to maintain a preference for corporates in Russia in aggregate over LatAm.


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GEM Cross-Asset Compass Currencies Tailwinds • Further DM growth stabilisation • High carry • Inflows from institutional investors Headwinds • Growing domestic vulnerabilities • Lack of reform momentum within EM • China slowdown and Fed policy still a threat

Outperform PLN, KRW, MXN We expect PLN and KRW to be strong performers due to their strong and/or improving external positions, low inflation and recovering growth momentum.

Underperform RUB, BRL, IDR These currencies suffer from ‘Dutch Disease’, with elevated real exchange rates, high inflation, deteriorating external positions, weak growth and question marks over reform appetite.

Local Rates Tailwinds • Stable commodity prices • Moderation in domestic growth and inflation • Foreign institutional inflows Headwinds • Higher DM rates • Currency weakness • Weakening fiscal outlook

Outperform Mexico, Russia Mexico should outperform thanks to progress on the reform agenda. Russian bonds are vulnerable to a weakening RUB in the near term, but we expect a rally further out in 2014 as inflation declines and the CBR cuts rates.

Underperform Indonesia, Poland Indonesia underperforms, given its weak fundamentals, current account deficit and rate hikes. Poland’s low yield does not offer enough protection from the threat of higher DM rates and improving domestic economy.

Sovereign Credit Tailwinds • Valuations no longer as stretched • Technicals supportive, with investors underweight risk on

aggregate • Inflows from institutional investors Headwinds • Higher DM rates • Need for structural reforms to adjust macro imbalances • Idiosyncratic issues in high-beta countries, creating potential

spillover risks

Outperform Mexico, Poland, Russia

In line with our more cautious view, we prefer credits that we expect to be more resilient to further EM weakness.

Underperform Brazil Slower growth, external vulnerabilities, a weakening fiscal balance and a leveraged private sector are some of the challenges facing the economy. Structural reforms remain the solution, yet elections in 2014 are likely to see these delayed.

Corporate Credit Tailwinds • Recent repricing has produced some pockets of value in some

high-quality, low-beta sectors/credits • External financing requirements over the next two years are

manageable • Core commodity prices (oil, copper, iron ore, coking coal)

expected to remain stable through 2014 Headwinds • Corporate balance sheets are carrying the burden of credit

growth excesses over the past five years • Weaker macro backdrop and potential sovereign fiscal

concerns will negatively impact corporates • Valuations look unattractive versus sovereign credit and core

credit markets

Outperform IG credits, with preference for quasi-sovereigns: Our allocation maintains an overweight preference for EM O&G, Russian BB (some M&M and telecoms); Turkish corporates with strong balance sheets; LatAm IG banks (ex-Brazil).

Underperform Brazil and Turkey banks: Excess credit growth, high private sector leverage and challenging macro fundamentals are likely to manifest on bank balance sheets. In Brazil, increasing fiscal concerns, potentially exacerbated by the QS banks, present a challenge to the sector.


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Study #1: Measuring Local Markets’ Vulnerability to QE

The path of Fed monetary policy will have an impact on short-term dynamics for EM, but we argue that over the medium-term fundamentals will dominate, and the different Fed scenarios will only alter the pace of adjustment in the absence of stronger domestic reform efforts and improved performance in EM.

The market reaction to various QE tapering scenarios would certainly differ in the short run, and although US monetary policy will likely have a diminishing influence over EM in the medium term, it is important nonetheless to gauge the vulnerability of EM assets to further rises in US Treasuries.

We choose to measure the sensitivity of EM local markets to US Treasuries by measuring their net gains/losses during specific periods when US rates had sharp moves higher or lower in 2013. We look at total returns to account for the carry. While it’s clear that sensitivities based on past events warrant caution, particularly for the high-beta countries, we believe that they serve as a good guide in this instance, given that we continue to deal with the same issue, namely the impact of tapering.

The most sensitive currencies and rates to sell-offs in US rates are those for Brazil, Indonesia, India, Mexico, Turkey and South Africa – all of which have suffered from deteriorating macro conditions, and (with the exception of Mexico) continue to exhibit important external imbalances and structurally high inflation due to strong credit growth.

Some may argue that their sensitivities have decreased somewhat – valuations are of course cheaper now, and carry is on the whole higher. And indeed, ZAR’s sensitivity may very well be lower, given that its current account vulnerability has been reduced. This is true for BRL as well since the BCB has shown its hand by intervening aggressively in the market. However, by and large, history is likely to be a reasonable guide and the order of the currencies should still be relatively similar in future episodes of sharply rising UST yields.

Sensitivities to rallies in US Treasuries are lower on average, which corroborates our view that one should fade rallies in EM on the back of QE tapering getting postponed. In particular, risk/reward in the coming months will favour those with a positive skew, on the left of the two charts on the page. In other words, many of the currencies and rates markets that were deemed more fundamentally vulnerable and that have shown a negative skew in their trading behaviour are set to underperform once more, in our view.

Exhibit 1

Sensitivity of EMFX to US Rates

-2.5-2.0-1.5-1.0-0.50.00.51.01.52.02.5

RU

BTW

DTH

BPE

NKR

WH

UF

MY

RC

ZKPH

PC

LPC

OP

SGP

PLN

ARS

TRY

INR

BRL

MX

NID

RZA

R

Rally

Sell-Off

Skew

Source: Morgan Stanley Research, Bloomberg; Sensitivity is defined as the EM return/UST return. Skew is defined as the difference between the sensitivity to US rates rallying and the sensitivity to US rates selling off.

Hence, our analysis shows that Hungary, Thailand, South Korea and Peru all have a positive skew in market sensitivities. We choose to discount the result for Russia to some extent, given that the economy faces significant domestic headwinds and is likely going to trade with a smaller (more negative) skew in the future.

Exhibit 2

Sensitivity of EM 10y Rates to US Rates

-2.0-1.5-1.0-0.50.00.51.01.52.02.5

HU

FTH

BR

UB

PLN

TWD

PEN

CZK CLP

KRW

ARS

MY

RSG

PTR

YM

XN

BRL

ZAR

INR

CO

PPH

PID

RRally

Sell-Off

Skew

Source: Morgan Stanley Research, Bloomberg


10


Study #2: Measuring EM Credit Vulnerability to QE Tapering We look at the recent price action to assess the sensitivity of EM credit to US rates, in order to judge how expectations on Fed policy may impact EM credit over the short term. We choose to assess the sensitivity of EM credit to US Treasuries by measuring net gains/losses during specific periods when US rates had sharp moves higher or lower in 2013. We look at total returns to take into account the carry. While it’s clear that sensitivities based on past events warrant caution, particularly for the high-beta countries, we believe that they serve as a good guide in this instance, given that we continue to deal with the same issue, namely the impact of tapering.

We found that the most sensitive countries to sell-offs include the members of the ‘Fragile Five’ in addition to Venezuela. While this comes as no surprise, we continue to see Indonesia as a better credit and one where stronger fundamentals should anchor the fair value versus the other Fragile Five, notably Turkey and South Africa. We believe that the high foreign ownership of the Indonesian sovereign bonds helps to explain why it features as the most sensitive credit.

Also shown as sensitive are many of the low-beta LatAm countries such as Brazil, Colombia and Peru. Slower growth, external vulnerabilities, a weakening fiscal balance and a leveraged private sector help to explain why Brazil has been more sensitive. While not facing similar challenges, Colombia and Peru are still seen as being impacted by a rise in rates, in addition to the very tight spreads at the beginning of the year leaving little cushion to absorb a rise in US rates. Mexico, meanwhile, displays a much lower sensitivity, showing that the reform momentum has provided added resilience.

CEE is by far the most resilient region to sell-offs. This is in part due to the wider spreads of these credits, providing both a cushion against the rising rates and higher carry. Yet, Poland, which is in fact one of the tighter credits, is also shown as less sensitive. This demonstrates the added cushion that CEE has had due to smaller current account deficits and a reduced exposure to a China slowdown.

To compare the performance in sell-offs versus rallies, we also look at the skew, simply defined as the rally sensitivity minus the sell-off sensitivity. Other than Ukraine, Brazil and Colombia also display slightly negative skews. Mexico only just shows positive skews. While Hungary featuring as one of the best skews should not come as a surprise, given its outperformance in 2013, South Africa is probably higher than most would expect.

Exhibit 1

Sensitivity of EM Credit to US Rates

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

ARG

LAT

HUN

POL

LITH

ROM

CRO

MEX

RUS

CHI

UKR

SOAF PE

R

COL

BRA

TURK

VEN

INDO

Sell-off

Rally

Skew

Source: Morgan Stanley Research, Bloomberg; Sensitivity is defined as the EM bond return/UST return

We also look at how the quasi-sovereigns performed versus the sovereign. Exhibit 2 shows the sensitivities to sell-offs at a country level, where the sensitivity of the quasi-sovereigns is an average across issuers, in cases where there is more than one quasi-sovereign issuer. While on average the sensitivity of quasi-sovereigns is higher than for sovereigns, we see quite a wide dispersion of values, from Hungary at 0.5 to Mongolia at over 2.0. Indonesia stands out as having a relatively wider gap between sensitivity of sovereigns and quasi-sovereigns to UST, with the latter being lower. At the other end of the range, quasi-sovereign corporates in Brazil and Turkey display a significantly higher sensitivity than their sovereign counterparts.

Exhibit 2 Quasi-Sovereign versus Sovereign Sensitivity to Treasuries

0.00

0.50

1.00

1.50

2.00

2.50

INDO

SOAF

HUN

MEX PE

R

RUS

VEN

CHI

CRO

COST

TURK BR

A

MO

NG

KAZ

MAL

Quasi Sovereign



11


Study #3: EM Corporates: Rising Leverage, Rising Risk EM economies have seen a meaningful rise in private sector debt over the past five years, reflecting in part their increasing importance to the overall economic environment in EM, as well as the favourable backdrop for external refinancing provided by low global interest rates. As the global financial markets confront the prospect of a rise in core market interest rates on the back of prospective moderation in the Fed’s balance sheet expansion, and with EM growth set to moderate, the most vulnerable and levered private sectors in EM might suffer.

Traditionally, investor focus has been on the external debt of EM sovereigns and corporates. This makes sense in the context of identifying the liquidity and funding risks that have historically plagued EM borrowers – the Achilles’ heel of EM. More recently, as EM economies and their respective banking systems and in some cases capital markets have developed, supported over the past five years by strong portfolio flows into EM, we have seen a meaningful increase in both corporate and household balance sheet leverage, with domestic banks remaining the dominant lender to EM corporates.

Banks leverage their balance sheets to the domestic economy, using funding from deposits, as well as wholesale funding markets, both domestic and external. A period of excessive credit growth followed by tightening in funding markets (both external and in some cases domestic) will eventually expose weak borrowers. In addition, as EM economies face the dimmest growth prospects for quite some time, the challenging operating environment for corporates and households can lead to deteriorating asset quality on bank balance sheets. Brazil and the economies in Asia have shown the most significant increases in non-financial corporate debt.

In order to determine which parts of the economy (banks, corporates, or both) carry the burdens and risks of the recent boom in credit in EM, we look at a number of factors: overall amount of external debt; proportion of short-term external debt; FX borrowings and recent pace of debt growth and overall stock.

Growth in private debt over the past few years has enabled EM corporates to fund themselves and to extend maturities of their debt. However, this meaningful increase in debt has occurred on the back of an ongoing deterioration in EM corporate balance sheets – a combination of weaker top-line growth and rising cost bases, in addition to a meaningful increase in debt. Our concerns stem from the negative impact of this earnings (flow) deterioration against a higher stock of debt.

As we expand our corporate fundamental universe to include a larger number of corporates, we find that while the trajectory remains unchanged, overall credit fundamentals are weaker. At the same time, we discover varying degrees of corporate concentration across various EM economies. Both factors give us insight into the broader risks facing all lenders to EM corporates.

Exhibit 1 highlights the deterioration in the broader EM corporate universe. On the whole, leverage ratios have been increasing over the past five years, against the backdrop of unchanged balance sheet liquidity and slightly lower profitability. While on a data point comparison basis, both balance sheet liquidity and EBITDA margin look relatively unchanged now versus 4Q08, they have weakened over this period from a peak seen in 4Q10.

We find that corporates in Mexico, Russia and South Africa are the best placed. At the other end of the scale, corporates in Brazil, Turkey, India and China face the greatest challenges from the recent accumulation of debt. Lastly, Indonesian corporates sit in the middle, with recent high credit growth, mitigated in part by relatively solid credit fundamentals.

Exhibit 1

Leverage of Broader EM Universe at Historical Highs, While Cash/ST Debt Back to 4Q08 Levels

4Q08 2Q13* 4Q08 2Q13* 4Q08 2Q13* 4Q08 2Q13*

Mexico 1.9x 2.3x 1.6x 2.1x 0.5x 1.4x 16% 14%Brazil 2.1x 3.3x 1.6x 2.6x 1.0x 0.8x 20% 17%

Russia 1.5x 2.4x 1.3x 2.1x 0.3x 0.6x 13% 14%Turkey 1.3x 3.1x 1.3x 1.8x 0.7x 0.6x 10% 10%

South Africa 1.5x 1.6x 1.1x 1.1x 0.6x 0.7x 13% 11%India 2.5x 3.0x 2.3x 2.8x 0.2x 0.2x 12% 10%

Indonesia 2.9x 2.6x 2.4x 2.4x 0.6x 0.6x 13% 14%China 2.9x 5.2x 2.2x 4.2x 0.7x 0.8x 12% 11%

Median 2.0x 2.8x 1.6x 2.3x 0.6x 0.6x 13% 12%

Gross leverage Cash/ST Debt EBITDA MarginNet leverage

Note: Blue square highlights the weakest values Source: S&P Capital IQ, Morgan Stanley Research; *Where 2Q13 unavailable, we use 1Q13.


12


Currencies: More Weakness Ahead

Sell Reduce Hold Accumulate Buy

• Macro deterioration in EM should result in further currency weakness. We are most bearish on currencies held back by weak or deteriorating current account positions, inflation challenges and, in some cases, poor internal debt dynamics. These include BRL, IDR and RUB in particular, but TRY, ZAR and INR as well. We are bullish on PLN, KRW and MXN.

More than the Fed for EM FX: The gradual tightening of monetary conditions associated with a rise in UST yields will likely place pressure on EM, unless accompanied by an increase in EM policy rates. However, this is not the only reason to expect EM currency weakness. We believe that many of the forces that have led to excess FX inflows over the past decade are in the process of unwinding. Higher global funding costs and the tightening of USD liquidity are just two examples of the unwinding of previously EM-supportive flows.

External vulnerabilities remain high: DM demand and Chinese growth look unlikely to support a recovery in EM led by strong exports or terms of trade. We expect US growth to be driven increasingly by capex, not consumption, and the former is not likely to provide much benefit to EM. Meanwhile, Europe remains under the threat of prolonged stagnation as deflation and low growth may become entrenched. As such, and amid large external deficits and high inflation in some of EM’s largest economies (India, Brazil, Turkey, South Africa and Indonesia), we believe that currencies are vulnerable to further nominal depreciation.

Domestic vulnerabilities are rising too: Fast credit growth and domestic leverage are of concern in economies such as Brazil, Turkey and China. We are concerned that some policy-makers will make a grab for growth by engaging in monetary and/or fiscal stimulus to support economic growth. Further demand-side stimulus would exacerbate already weak external positions by stoking domestic demand and high domestic leverage by encouraging more borrowing. EM needs to engage in reform to boost productivity growth, particularly with demographics taking a less growth-supportive turn.

It’s not all bad news: Some markets do not suffer from obvious domestic or external vulnerabilities, despite significant exposure to foreign capital. Poland and Mexico, for example, have seen large levels of foreign bond inflows; however, these inflows have not stimulated excess domestic demand or placed undue pressure on external accounts. As such, we see these currencies as less vulnerable.

Furthermore, not all EM economies suffer from competitiveness challenges. Outside the ‘Fragile Five’ (ZAR, TRY, INR, IDR, BRL) and RUB, pressure on currencies from high inflation is negligible. We expect continued differentiation in the market based on these themes, and we are overweight PLN, KRW and MXN in particular.

Exhibit 1

EM Currency Index Bull/Bear Fan Forecast

95

97

99

101

103

105

107

109

111

Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14

103.8

Source: Morgan Stanley Research, Bloomberg; Of the currencies discussed, this index excludes ARS, NGN and VEF forecasts.

Exhibit 2

Regional Currency Index Forecast Paths

98

99

100

101

102

103

104

105

106

Dec-13 Mar-14 Jun-14 Sep-14 Dec-14AXJ CEEMEA LatAm EM

Source: Morgan Stanley Research forecasts

Exhibit 3

CPI Differential for F5 + RUB High and Rising

-2

0

2

4

6

8

10

12

14

16

03 04 05 06 07 08 09 10 11 12 13

F5+RUB CPI Differential with USD, EURRest of EM CPI Diffential with USD, EUR

Source: Morgan Stanley Research, Haver Analytics


13


Local Rates: Trading Higher


• Rising core rates and currency weakness will set up the year for steeper curves in EM – although some markets are bound to be more affected.

• We are overweight Russia, Korea and Mexico for 2014, and look to go tactically underweight the ‘Fragile Five’ despite the large carry.

Consistent with the steady rise in core rate market yields in our baseline scenario, we see further widening and steepening in EM local rate curves. Our baseline expectation of a further bout of EM currency depreciation – on the back of deteriorating sovereign and corporate credit fundamentals – suggests we will see a pass-through of FX volatility to EM local rates. However, this is likely to adversely impact some rate markets more than others, particularly countries perceived as externally vulnerable. Mitigating these two exogenous factors are prospects for domestic growth and inflation moderation, which may anchor the front ends of curves and magnify the scope for rate curve-steepening.

In CEEMEA, Russian bonds remain vulnerable in the near term to the weakening RUB, but we expect a rally further out as inflation declines and the CBR cuts rates. Israel should also offer good risk-adjusted returns. We also project a relatively high return for South African bonds, but volatility is likely to be high too, given our expectation of further weakness in ZAR. Polish bonds should underperform, as their low yield does not offer enough protection from the threat of higher DM rates and an improving domestic economy.

In LatAm, we expect increased differentiation between the two largest markets, Mexico and Brazil, keeping in mind that differentiation can only go so far in the context of higher US Treasury yields. Steeper curves remain our baseline scenario, particularly in Brazil, where structural inflation and a weakening fiscal outlook bode poorly for the curve. And while, thanks to Mexico’s reform agenda, we believe that Mbonos are set to be among the outperformers by end-2014, we suspect the path there will remain volatile, given the context.

In AxJ, while the China reform is an important positive for the medium-term outlook, deleveraging is an important challenge in the near term. As countries start to normalise monetary policy, we expect most Asian bond curves to bear steepen in 1H14. In 2H, most markets should flatten along with rate hikes, especially Korea and Thailand. And given India and Indonesia’s weak fundamentals and current account deficits, we suggest that investors stay neutral or look to tactically go underweight bonds at richer levels.

Exhibit 1 EM Local Rates Bull/Bear Fan Forecast (%)

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

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

6.7

6.1

Source: Bloomberg, Morgan Stanley Research forecasts; *Weighted average of 20 countries

Exhibit 2 Regional Rates Forecast Paths

2.2

3.0

3.8

4.6

5.4

6.2

7.0

7.8

8.6

9.4

Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14

AXJ CEEMEA LatAm EM Source: Morgan Stanley Research forecasts

Exhibit 3 EMFX Weakness Pass-through to EM Rates

85

89

93

97

101

105

0

50

100

150

200

250

300

Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13EM 10y Risk Premium (bp) USD/EM



14


Sovereign Credit: Positioning for Further Spread Widening


• We would use any tightening in spreads to reduce our exposure, preparing for further EM weakness in 1H14.

We believe that sovereign credit is set to face another year of negative returns: Reasons include increasing UST yields, weak EM growth and a need for structural reforms to adjust macro imbalances. The upward pressure on spreads is likely to intensify in early 2Q14 as investor attention shifts from external imbalances to domestic issues, notably the fiscal trajectory and upcoming elections.

We move our stance to Reduce from Hold: We are strategically bearish for 2014, though material weakness may not materialise until later in 1Q14. In fact, our 2013 year-end target remains 360bp and the technical support provided by seasonal inflows in January may push spreads tighter. Yet, we would use this as an opportunity to reduce exposure – i.e., sell on strength – and to implement our strategic bearish view.

A continued defensive allocation: We are overweight Mexico, Russia, Poland and other CEE countries, to a lesser degree. Brazil remains our top underweight due to slower growth, external vulnerabilities, a weakening fiscal balance and a leveraged private sector. Given our cautious stance, we move Turkey and South Africa to neutral/underweight, as we believe that they will remain high-beta credits. Of the ‘Fragile Five’, we maintain a preference for Indonesia and therefore maintain it at market-weight. Although our base case does not contemplate any sovereign default, we cannot rule out a sharp deterioration of the challenging FX and funding situations in Venezuela and Ukraine. We remain market-weight, as carry considerations make timing key, but with a very cautious bias on both.

Keeping in mind the spillover risks: Should the deterioration in economic conditions in Venezuela continue or even accelerate, this would likely have a spillover impact on the rest of the market, in our view. Potential channels of contagion are related to economic ties, financial linkages and market dynamics. The first two are unlikely to have a significant impact in the absence of a negative tail event, in our view. However, ongoing deterioration could still weigh on the index performance, negatively affecting retail flows to real money investors. Should retail outflows accelerate rapidly, more liquid names with overweight positioning (i.e., Russia, Brazil and Mexico) might underperform in the first stage. However, it is worth highlighting that institutional flows are likely to be more resilient, potentially providing some support to the asset class.

Exhibit 1 EM Sovereign Spread Bull/Bear Fan Forecast (bp)

354

200

250

300

350

400

450

500

550

Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15

Source: Bloomberg, Morgan Stanley Research forecasts; Based on EMBIG spread index

Exhibit 2 Forecast Paths for IG versus HY (bp)

0

20

40

60

80

100

120

140

Current 4Q14 1Q14 2Q14 3Q14 4Q14

EM IG Non-IG


Exhibit 3 We Expect Another Year of Negative Returns (%)

4%

6%

8%

10%

12%

14%

16%

-20%

-10%

0%

10%

20%

30%

40%

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

EM Credit Return EM Yield, % (RHS) Average Return Source: Bloomberg, Morgan Stanley Research forecasts


15


Corporate Credit: Chasing Quality


• We are defensively positioned as corporate valuations are set to adjust to rising core yields, a weaker operating backdrop and overall higher balance sheet leverage.

EM corporates are set to continue the repricing which began in 2Q13: With investors increasingly focused on underlying fundamentals, at both the sovereign and corporate balance sheet level, we reiterate our call for further credit differentiation/fragmentation across the asset class. At the aggregate level, we expect corporate credit to underperform sovereign credit (see Exhibit 1).

We see two reasons for this: First, sovereign spreads, while also set to reprice further, in our view, already in part reflect weakening fundamentals – sovereign spreads are 50bp wider than 12 months ago – while corporate credit spreads on aggregate are unchanged. Second, as we recently highlighted in Rising Leverage, Rising Risk, November 18, 2013) domestic credit growth has pushed corporate balance sheet leverage to historically high levels in some sectors. We expect the combination of rising core yields and the continuation of slower growth prospects across EM economies to start to pressure debt-servicing capabilities. With external funding requirements of EM corporates manageable over the next two years (see Exhibit 3), thanks to recent active primary markets, we think that investors should focus on domestic lending conditions and bank asset quality.

Investor focus on fundamentals: We expect increased differentiation and stock selection to reward investors in 2014. Our sector and overall allocation remain broadly unchanged. We maintain our preference for quasi-sovereign (QS) and BBB rated corporates. The latter still represent the most attractive risk/reward versus EM HY and versus US BBB. We selectively add names in the higher-quality BB rated corporates. Along these lines, we remain OW the O&G sector – the sector is dominated by liquid, high-quality QS credits. We see select value in Russian M&M credits and telecoms (MW). Select Turkish corporates offer relatively attractive value underpinned by strong fundamentals. We move utilities to UW – the sector is defensive in nature, but tight spreads and sovereign fiscal concerns will limit performance, in our view. In the financials space, we move Brazilian banks to underweight, in line with our sovereign credit view. High-quality banks in the rest of LatAm (Colombia and Peru) offer some relatively attractive valuations. Lastly, we prefer Russian banks over Turkey banks. .

Exhibit 1 EM Corporate Bull/Bear Forecast (Spread to Sovereign)


Exhibit 2 Leverage of Broader EM Universe at Historical Highs, While Cash/ST Debt Back to 4Q08 Levels

0.0x

0.1x

0.2x

0.3x

0.4x

0.5x

0.6x

0.7x

0.8x

0.9x

1.0x

1.3x

1.5x

1.8x

2.0x

2.3x

2.5x

2.8x

3.0x

4Q08

1Q09

2Q09

3Q09

4Q09

1Q10

2Q10

3Q10

4Q10

1Q11

2Q11

3Q11

4Q11

1Q12

2Q12

3Q12

4Q12

1Q13

2Q13

Cash

/ST D

ebt

Leve

rage

Net Leverage Gross Leverage Cash/ST Debt

Source: S&P Capital IQ, Morgan Stanley Research

Exhibit 3 External Funding Requirements for EM Corporates in 2014 and 2015 Are Manageable

62

35 27 23 22 13 5 6 4 7 3 2

59

2228

1713 19

10 4 5 1 4 0

33%41%

48%

27%

20% 14%

54%

36%

77%

25%

33%

51%

0%

20%

40%

60%

80%

100%

0

20

40

60

80

100

120

140

Russ

ia

Mex

ico

Braz

il

U.A.

E.

Turk

ey

S. A

rabi

a

Qata

r

Chile Ka

z

Arge

ntin

a

Ukra

ine

Peru

US$bn2014 2015 Bond amortizations (% of total loans and bonds, RHS)

Source: Dealogic

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


16


Regional Market Views: Latin America

FX Local Rates Credit

Argentina FX Change: 33.53% Forecast

-40%-30%-20%-10%

0%10%20%30%40%

56789

4Q13 1Q14 2Q14 3Q14 4Q14

We expect the authorities to allow the peso to depreciate more quickly than inflation in 2014, leading to a real depreciation that starts to slowly address the overvaluation of the currency. This, along with tightening of capital controls, should reduce the erosion of international reserves. However, without more substantial adjustments – fiscal, monetary and regulatory – we suspect confidence and growth will remain weak.

On one hand, US court rulings are still pending, which leaves much uncertainty. On the other are bond prices that have risen significantly in the past three months to reach near two-year highs, meaning a lot of good news is already priced in. We therefore remain market-weight but with a preference for the par bonds, despite these bonds having lagged the discount bonds recently.

Brazil FX Change: 11.3% Forecast

-15.0%-10.0%-5.0%0.0%5.0%

10.0%15.0%

2.2

2.4

2.6

2.8

4Q13 1Q14 2Q14 3Q14 4Q14

Buy 2015

5y yield change Asset Preference-1.00

-0.50

0.00

0.50

1.00

BearSteepening

Buy Jan-2019Buy 2021

Sell 2041

Asset PreferenceSpread Change:121

Steepening

We remain bearish on BRL, as the low growth/high inflation balance that reflects flaws in the model is poised to deteriorate further in 2014, in our view. Conflicting fiscal and monetary policies and risks of a ratings downgrade due to eroding fiscal results also contribute. Valuations have improved but the currency needs to adjust further, as it remains overvalued and the probability of reforms ahead of the presidential election in October is low. Tighter monetary conditions and official intervention will have to continue in order to provide some support and limit volatility. We look to buy dollars into strength and cross against other high-yielding currencies to offset the carry.

We expect a steeper curve in Brazil, where structural inflation and a weakening fiscal outlook bode poorly for the curve, and see NTNF 2019 yields heading towards 13.20% in 4Q14. The market also looks set to increasingly price in an even more aggressive tightening cycle once elections are over to slow credit growth, and we expect that the capital losses will not compensate for the (vol-adjusted) carry.

Slower growth, external vulnerabilities, a weakening fiscal balance and a leveraged private sector are some of the challenges facing the economy. Structural reforms remain the solution, yet elections in 2014 are likely to see these delayed. Heavy investor positioning in Brazil offers little support. Therefore, we see spreads remaining under upwards pressure and expect the decoupling from the other low-beta LatAm credits to continue. We maintain Brazil as our main underweight.

Chile FX Change: 1.45% Forecast

-3%-2%-1%0%1%2%3%

400450500550600

4Q13 1Q14 2Q14 3Q14 4Q14

Buy 2020

5y yield change Asset Preference-1.50-1.00-0.500.000.501.001.50

Unchanged

Buy 2022

Sell 2042

Asset PreferenceSpread Change: 48 Steepening

Concerns about potential economic and political reform in the new government, together with lower interest rates and the explicit central bank bias for a weaker currency, should continue to weigh on CLP. We also expect downward pressure from lower foreign direct investment into the mining sector as multinational companies continue adjusting their plans to the new outlook. We expect CLP to fall to 540 by end-2014.

Bearish local sentiment and a high liquidity premium will keep Chile’s Global 2020 bond vulnerable to another sell-off, in our view, generated by higher DM rates. Unsupported by limited further cuts and low carry, we forecast year-end yields at 6.05%. We also see upside risk to our call due to continued political noise from election results and the new administration.

While the exposure to the global economy is high, in particular to China, Chile has in fact weathered the problems in 2013 very well. However, with its very tight spreads and hence limited room to absorb a rise in core rates, Chilean bonds have still underperformed. As core rates volatility will remain a risk, we maintain our neutral/underweight stance in Chile, preferring the belly of the curve, given that the 10s30s look very flat.


17



Colombia FX Change: .96% Forecast

-1%

0%

1%

17001800190020002100

4Q13 1Q14 2Q14 3Q14 4Q14

Buy 2024


-0.50

0.00

0.50

1.00

BullFlattening

Buy 2021Buy 2023

Sell 2037Sell 2041

Asset PreferenceSpread Change: 52Belly

Outperforming

Fundamentals remain positive and we expect the currency to remain relatively stable and outperform its peers in the region. Potential weakness from higher US rates and the stronger dollar should provide an opportunity for the central bank and the government to scale down dollar purchases and intervention and allow the currency to stay near the preferred range between 1,900 and 1,950. Yields of domestic government bonds are still high and plans to lift obstacles to foreign participation could attract new capital inflows. We are mindful of legislative and presidential elections in March and May, but do not see any significant risks from these. Downside risk to oil prices is a concern.

A chance for further rate cuts, given our view that the rebound this year will be weaker than expected, as well as the possibility of opening its local bond market to foreigners, bode well for the Coltes ’18. Despite its higher yields, the rise in US rates will most likely cause the long end of the curve to sell off nevertheless towards 6.65% by end-2014.

A progressing structural reform agenda makes us more constructive on future growth; however, infrastructure builds are expected to start only in 2H15. Coupled with recent data showing a slowing of domestic demand, this means we need to see more evidence of growth having troughed. While valuations are again at the wider ends, Colombia continues to be among the more sensitive credits to core rates moves, and we therefore move back to market-weight. Previous underweight investor positioning, which is now back to neutral versus the benchmark, is a further reason.

Mexico FX Change: - 4.65% Forecast

-5%

-3%

0%

3%

5%

1112131415

4Q13 1Q14 2Q14 3Q14 4Q14

Buy 2017


-0.50

0.00

0.50

1.00

BellyOutperforming

Buy Mar-2022Buy 2023

Sell Mar-2019Buy CDS


Outperforming

The positive impact from the reforms is already in the price, we believe, with perhaps only marginal upside left from the final details of the energy bill early in 2014. Further upside next year should come from economic growth that is poised to benefit from better public budget execution and stronger activity in the US manufacturing sector. Valuations and technical market positions are also supportive. We expect MXN to reach 12.50 by end-2014. While still constructive, we remain cautious about volatility and a high beta to global risks, which implies that timing is important, but also that there should be opportunities to buy into weakness.

We favor Mbonos into next year, particularly the belly of the curve, which should benefit from positive news on the energy reform as well as the anchoring of inflation expectations. We forecast Mbono ’18 yields to end the year at 5.60%. Given Mbonos’ sensitivity to higher US rates, we suspect that the long end of the curve will be more vulnerable.

Structural reforms and a strong manufacturing link to the US should result in Mexico outperforming, and we maintain Mexico as one of our largest overweights. High duration and little scope for spreads to absorb a rise in core rates have meant that bonds have suffered in line with the market, and this leaves valuations less stretched. With CDS trading tighter than bonds, a constructive view is best expressed through the bonds.


18



Peru FX Change: 5.38% Forecast

-6.0%-4.0%-2.0%0.0%2.0%4.0%6.0%

2.70

2.80

2.90

3.00

4Q13 1Q14 2Q14 3Q14 4Q14

Buy 2020


-0.50

0.00

0.50

1.00

Unchanged

Buy 2019Buy 2025

Sell 2037


Outperforming

We expect PEN to maintain a steady and moderate downward trend and reach 2.95 by end-2014. Unattractive valuations and concerns about commodity prices, higher US interest rates and the high participation of foreigners in local markets should be the main drivers. Fundamentals are still positive and together with central bank intervention should limit volatility and moderate the adjustment. In our view, PEN remains a good defensive play and still has high carry after being adjusted for volatility.

Domestic political noise and the weak PEN bode poorly for the Soberano 2020, which we suspect will end the year closer to 5.80%, in line with steeper EM bonds elsewhere. The lack of liquidity and high foreign ownership make the bond risky, in our view, particularly given risks of another sharp sell-off in US treasuries.

Overall low levels of external debt and high reserves mean that a rise in core rates is not a pressing issue. Furthermore, while the current account deficit is high, it is more than financed by FDI inflows. The potential weak link would be China, due to exports, yet, with growth in China appearing to stabilise, we do not expect this to cause a significant growth slowdown for now. Therefore, with Peruvian macro fundamentals that remain sound, reasonable valuations and investors in aggregate underweight, we maintain a slight overweight in Peru with a preference for the belly of the curve.

Venezuela FX Change Forecast

-100%

-50%

0%

50%

100%

579

1113

4Q13 1Q14 2Q14 3Q14 4Q14

Buy 2019Buy 2020Buy 2023Sell 2027Sell 2028


BellyOutperforming

The risk of a devaluation is ever present, but the timing remains politically driven. And with the parallel rate now near Bs$70/dollar (versus the official rate of Bs$6.30/dollar) the magnitude of any potential devaluation, not just the timing, remains an open question. Meanwhile the economic outlook is challenging, given the regulatory uncertainty, interventionist state and concerns over private property protection.

The economic situation clearly remains very challenging – notably the shortage of dollars, heavy funding needs, high inflation and lack of basic goods. The current risk/reward of long positions therefore remains unattractive. Although we are inclined to sell tactically on any rebound, the high carry requires some additional consideration when assessing our portfolio allocation, given the longer time horizon. Therefore, we reiterate our market-weight stance with a bearish bias.


19


Regional Market Views: CEEMEA


Czech FX Change: - 1.34% Forecast

-2%

-1%

0%

1%

2%

2627272828

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2018


-0.25

0.00

0.25

0.50

BearSteepening

We see an asymmetric risk profile around EUR/CZK for next year, whereby risks of a move in the cross higher than the stated target exchange rate of 27 are more likely than moves lower. As such, we recommend buying EUR/CZK on dips towards 27, and would not rule out a further policy-induced rise in EUR/CZK over the year. Inflation will be the key macro variable to track as the main driver for the CNB’s intervention strategy.

We expect a gradual rise in Czech bond yields, but mainly in the long end of the curve. The front end should be anchored by the dovish, interventionist policy of the CNB but has already rallied and largely priced in currency intervention policy. Long-dated yields, on the other hand, should rise as DM rates increase.

Hungary FX Change: - 2.45% Forecast

-3%-2%-1%0%1%2%3%

280

290

300

310

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2018


-0.50

0.00

0.50

1.00

BearSteepening

Buy $2023Buy $Nov-2023

Sell $2041


Outperforming

HUF should receive some support from a stable current account surplus and improving growth conditions, with the Funding for Growth Scheme being used and the NBH having cut rates aggressively through 2013. This backdrop should allow EUR/HUF to grind slowly lower towards 290. The tail risk would be even more dovish policy from the NBH than our economist expects, which may undermine HUF, especially against regional peers.

We expect unchanged to slightly lower yields at the front end of the curve, as the dovish NBH stance remains firmly in place, while the long end sells off in line with the rest of EM local rates. Still the market should again outperform most investable local markets in 2014, given benign domestic and eurozone inflation dynamics and the lack of major negative surprises on the structural front.

With a still-high spread and a current account surplus, Hungary will likely continue to absorb the rise in core rates better than most credits. A reduced sensitivity to China is an additional positive. With all IMF debt repaid, Hungary has already started pre-funding 2014, and we do not see the larger-than-average 2014 external debt repayments as an issue. Hence, with investor positioning still underweight Hungary, we maintain our neutral/overweight stance and expect Hungary to outperform. The FX mortgage situation remains a risk to be watched, particularly given elections in 2014.

Israel FX Change: - 1.21% Forecast

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.43.53.53.63.6

4Q13 1Q14 2Q14 3Q14 4Q14

Buy 2016


0.00

0.50

BullSteepening

USD/ILS has been broadly flat at 3.55 as positive BoP flows related to gas production are being offset by the BoI’s USD purchasing programme. We expect the currency’s safe-haven features and the economy’s improving external balances to see USD/ILS end the year closer to 3.45, but we expect that it will be a slow move lower as the BoI maintains a preference for a weaker exchange rate.

We see only a marginal increase in ILGOV yields in 2014, as the market is once again likely to avoid the volatility in most EM local markets, given the dovish BoI stance aimed at preventing currency strength and low foreign ownership. The market is likely to outperform most EM local bond markets and USTs.

A positive FX change is USD rising versus EMFX


20



Poland FX Change: - 3.45% Forecast

-4%

-2%

0%

2%

4%

3.8

4.0

4.2

4.4

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2018


-0.50

0.00

0.50

1.00

BearSteepening

Buy $2022Buy $2023Buy EUR 2022Sell EUR 2018

Asset PreferenceSpread Change: 50 Flattening

Poland has been a front-runner in the recovery, and we believe it is one of few EM economies well positioned for 2014. Growth is on an improving trend, the NBP has stopped easing policy, the trade deficit is narrowing and structural reforms are not as pressing an issue as in regional peers. As such, we expect cyclical improvements to drive EUR/PLN lower over the forecast horizon. The key risk is the heavy stock of foreign-owned local government bonds; however, we do not envisage a period of financial risk that would prompt a reduction in this stock.

We see a further gradual rise in Polish bond yields in 2014, given the end of the NBP easing cycle and likely rise in DM yields. The curve is likely to steepen further, and volatility should increase going forward, as pension funds withdraw from the bond market while foreign inflows remain subdued.

The Polish economy continues to show positive signs, with a narrowing current account deficit and growth expected to accelerate further to 3%Y in 2014. The lack of reliance on China’s growth path is also a plus. Recent widening in bonds spreads has improved valuations. Together with the improving fundamentals and favourable technicals via underweight fund positioning, this makes us more constructive on Polish bonds. We upgrade Poland to overweight.

Russia FX Change: 5.68% Forecast

-6.0%

-3.0%

0.0%

3.0%

6.0%

3032343638

4Q13 1Q14 2Q14 3Q14 4Q14

Buy 2016


0.00

0.50

BullSteepening

Buy 2022Buy 2023

Sell 2017Sell 2042


We look for a meaningful depreciation in RUB for 2014 and recommend adding to short positions against USD. There has been a deterioration in the BoP in Russia, which is likely to continue gradually in the coming quarters. In addition, the level of intervention from the CBR has diminished significantly, which means that not only is RUB much more vulnerable to an oil price decline thanks to the erosion of the external surplus, but also that the CBR will not be there to mitigate the effects. At the same time, the Ministry of Finance will be an active buyer of USD for the Reserve Fund should the budget have excess revenues.

OFZs are likely to struggle in the near term as the CBR delays easing and RUB comes under pressure, leaving the market vulnerable to a wider sell-off in fixed income. As we move further into next year, we see lower yields, particularly at the front end and belly of the curve as the CBR starts cutting rates.

Growth is currently lagging, and with a shrinking current account surplus Russia remains vulnerable to a fall in oil prices. Reforms that are still lacking add to the problems. However, to the extent that we do not expect oil prices to fall much further, hence reducing fiscal risks, we believe that Russia will remain more resilient in a generally weak EM environment. We therefore maintain Russia at overweight despite acknowledging that significant spread compression appears unlikely, particularly given the already heavy investor exposure.

South Africa FX Change: 8.12% Forecast

-10%

-5%

0%

5%

10%

9

10

11

12

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2018


-0.50

0.00

0.50

1.00

Unchanged

Buy 2024

Sell 2041


Valuations on ZAR have adjusted significantly following a prolonged weakening trend in the currency against USD and trading partners that started in mid-2011. This should help to stabilise the currency into year-end; however, medium-term challenges remain related to the labour market and elections in 2014. Also, South Africa’s terms of trade remains sensitive to China-related commodity price risks. As such, we forecast USD/ZAR to head as high as 11 over the coming 12 months.

Yields are likely to remain range-bound in the near term, as the risk premium is high after the recent sell-off. The front end should outperform, given the decline in headline inflation, but the long end should remain vulnerable to a further rise in DM rates and ZAR weakness. Further revisions to the trade balance figures would be a positive surprise.

Problems include a wide and sticky current account deficit, a reliance on China and elections in 2014 that mean the macro reforms needed to improve growth may be pushed out. While the lack of significant external bond payments in the next few years and a government committed to prudent fiscal management make us less worried in the short term, we believe that South Africa will remain a high-beta credit. Despite its high spreads, we therefore reduce exposure to neutral/underweight.



21



Turkey FX Change: 7.47% Forecast

-10.0%

-5.0%

0.0%

5.0%

10.0%

1.902.002.102.202.30

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2015

5y yield change Asset Preference-1.50-1.00-0.500.000.501.00

BearFlattening

Buy Mar-2022

Buy 5Y CDSSell 2043


We maintain a bearish medium-term view on TRY for 2014 as it remains vulnerable to a potential increase in USD demand when tapering starts next year. On the positive side, the CBT has shown more willingness to tighten policy, and to some extent this reduces the severity of the bear case scenarios. However, we still expect TRY to depreciate against USD, reaching 2.17 by year-end.

Turkish bond yields should remain volatile and under pressure into 2014, as the country is one of the most exposed in EM to a withdrawal of global liquidity and a rise in DM rates. The weakness in TRY and consequent risk to inflation is likely to keep the CBT’s tightening bias in place. We don’t see a sustained decline in Turkish yields over our forecast horizon.

Turkey has repriced significantly wider, with spreads near double the lows seen in May. While valuations may therefore look more attractive, a still-wide current account deficit, high funding requirements and a leveraged private sector make us cautious. We therefore reduce our exposure to Turkey to neutral/underweight, expecting it to remain a high-beta credit. With a very negative CDS-bond basis, a bearish stance is currently best implemented through buying CDS protection, in our view.

Ukraine

Buy Nov-2016

Sell 2023


Steepening

In the absence of a policy change and given unfavourable external market funding conditions, the financing of the current account deficit, public sector redemptions and seasonal household FX purchases will remain the key focus. The considerable carry makes timing key, and we believe that remaining neutral is the preferred stance going into the end of the year, before reassessing the position in January.



22


Regional Market Views: Asia Ex-Japan


China FX Change: - 3.02% Forecast

-5%

0%

5%

5.6

5.8

6.0

6.2

4Q13 1Q14 2Q14 3Q14 4Q14

Buy 2018


0.00

0.50

BullFlattening

The USD/CNY fix should remain stable at current levels, given the significant REER adjustment that has taken place in 2013. Although the Third Plenum revealed positive reforms, including a potential move towards market-determined FX rates, we are cautious about the impact that rising money market rates will have on GDP growth and local assets.

Some of the sharp bear-steepening that occurred due to regulation-related uncertainty this year should reverse in 2014. Growth is likely to go lower, increasing allocation in bonds. We also do not expect the new financial market regulation to force a sharp deleveraging like the one that caused a rise in yields in the summer of 2013.

India FX Change: .88% Forecast

-1%

0%

1%

60626466

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2018

5y yield change Asset Preference-1.50-1.00-0.500.000.501.001.50

Parallel shift

The outlook for INR is improving as: i) The current account balance is showing signs of improvement; ii) RBI measures have helped to bring in USD flows, supporting the balance of payments; and iii) INR is close to fair value and carry is attractive. That said, INR is still sensitive to global risk sentiment, and upcoming elections could increase risks for the currency.

We are biased to pay rates in INR, given the risks of fiscal slippage and stubbornly high inflation. We think that the RBI may not be able to ease liquidity, given that the risks to the currency from Fed tapering remain going into 2014. We expect the curve to shift higher by 80-100bp in 2014 on policy hikes and the impact from globally rising rates.

Indonesia FX Change: 3.64% Forecast

-4%-2%0%2%4%

11000

12000

13000

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2018

5y yield change Asset Preference-1.00-0.500.000.501.001.50

BearSteepening

Buy 2022Buy 2023

Sell 2017Sell 2043


We believe that further REER adjustment is required in IDR to increase export competitiveness and contain the current account deficit. Given Indonesia’s high inflation, further nominal depreciation is also required to maintain REER at fair value. We expect IDR to depreciate to 12,400 by end-2014.

BI has hiked rates by 175bp in 2013, although further adjustment may be required to control inflation and high import growth, while also providing yield support for foreign investors in local bonds. In addition, we expect the IDR curve to steepen in the environment of rising global rates.

We continue to see Indonesia as the better credit among the ‘Fragile Five’, where stronger fundamentals should anchor the fair value versus both Turkey and South Africa. We believe that the high foreign ownership of Indonesian sovereign bonds helps to explain why it continues to trade with a high beta. We prefer the belly of the curve, given a flat 10s30s curve, but maintain at market-weight given our overall bearish view for the asset class.



23



Thailand FX Change: 2.96% Forecast

-3%-2%-1%0%1%2%3%

3031323334

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2018


-0.50

0.00

0.50

1.00

BearSteepening

THB is among the more vulnerable currencies in AxJ, given a declining current account and vulnerability to foreign investor outflows as global rates rise. Continued political tensions and a still ongoing rate cut cycle are also not supportive for THB.

We expect the Thailand curve to steepen further, given the high beta to US rates. High leverage in the economy and a current account dipping into deficit are also factors that make Thailand vulnerable to a rising rate environment.

Korea FX Change: - 5.5% Forecast

-6%-3%0%3%6%

950

1050

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2018


0.00

0.50

BearSteepening

We are positive on KRW, given Korea’s solid current account, considerable exports recovery and continued ‘quality’ foreign inflows in its domestic market. BoK interventions are the main risk but there has been some political pushback on interventions, given mounting FX losses for BoK.

While we expect Korea’s curve to steepen along with the rest of the region, we believe that KTBs are attractive relative to other Asian peers and even DM bonds. The growth recovery in Korea has continued while inflation remains benign.

Malaysia FX Change: 2.5% Forecast

-3%

0%

3%

3.1

3.3

3.5

4Q13 1Q14 2Q14 3Q14 4Q14

Sell 2023


0.00

0.50

BearSteepening

Malaysia’s GDP and current account have remained stable through 2013. However, in the medium term, higher global yields from Fed QE tapering and slower Chinese growth should weigh on Malaysia’s balance of payments, increasing depreciation pressure on MYR, in our view.

The front end of the curve is anchored by BNM and the 2014 budget maintained a fiscal consolidation path. However, given the high foreign holdings exposure in Malay bonds, we expect that the curve could bear-steepen further along with rising global rates.

Philippines FX Change: 2.99% Forecast

-3.0%-2.0%-1.0%0.0%1.0%2.0%3.0%

42

44

46

4Q13 1Q14 2Q14 3Q14 4Q14

The Philippines’ current account remains steady. GDP growth may see a setback from the devastating typhoon, although there is sufficient fiscal leeway for recovery measures. Although fundamentals remain solid, the peso should continue to trade in line with investor risk sentiment on AXJ into 2014.



24


Morgan Stanley EM Forecasts

Currencies Local Rates 5y Sovereign Bonds 10y

1Q14 2Q14 3Q14 4Q14 1Q14 2Q14 3Q14 4Q14 1Q14 2Q14 3Q14

4Q14

Latin

Am

eric

a

Argentina 6.74 7.23 7.71 8.20 Brazil 2.45 2.53 2.65 2.60 13.00 13.50 13.80 13.50 242 277 292 302 Chile 530 535 538 540 5.50 5.80 5.95 6.05 117 127 134 137 Colombia 1950 1930 1940 1950 6.30 6.45 6.55 6.65 172 184 193 197 Mexico 13.00 12.90 12.75 12.50 5.10 5.30 5.50 5.60 165 177 185 189 Peru 2.90 2.92 2.94 2.95 5.45 5.60 5.70 5.80 182 199 207 211 Venezuela 12.00 12.00 12.00 12.00 1410 1490 1556 1573

CEE

ME

A

Czech Rep. 27.00 27.00 27.00 27.00 0.98 1.13 1.13 1.13 Hungary 296 295 295 294 5.13 5.28 5.38 5.48 347 357 363 369 Israel 3.52 3.50 3.50 3.48 2.37 2.52 2.52 2.52 Nigeria 158.2 158.2 158.2 158.2 Poland 4.18 4.14 4.10 4.06 4.04 4.29 4.44 4.54 176 185 192 197 Romania 4.42 4.40 4.40 4.38 4.85 5.00 5.10 5.20 247 257 267 273 Russia 33.5 34.0 34.5 35.0 7.56 7.81 7.56 7.56 213 228 237 242 S. Africa 10.50 10.80 10.90 11.00 7.51 7.76 7.91 8.01 269 289 299 304 Turkey 2.10 2.15 2.17 2.17 9.56 10.06 10.06 10.06 284 300 310 315

Asia

ex-

Japa

n

China 6.08 5.99 5.99 5.91 4.28 4.24 4.17 4.14 Hong Kong 7.80 7.80 7.80 7.80 1.24 1.49 1.69 1.77 India 62.0 64.0 64.0 63.0 9.02 9.32 9.52 9.67 Indonesia 11600 11800 12200 12400 8.57 8.96 9.30 9.38 266 276 281 286 Korea 1050 1025 1000 1000 3.38 3.51 3.69 3.82 Malaysia 3.21 3.24 3.27 3.30 3.49 3.61 3.77 3.84 Philippines 43.7 44.2 44.6 45.1 Singapore 1.26 1.27 1.28 1.29 1.24 1.36 1.43 1.46 Taiwan 29.60 29.75 29.90 30.05 1.19 1.29 1.38 1.43 Thailand 32.20 32.50 32.70 33.00 3.54 3.68 3.94 4.16



25


Exhibit 1 Local Markets Return Base Case Forecasts, 4Q14

-15%

-10%

-5%

0%

5%

10%

15%

MX

N

CN

Y

KR

WILS

INR

PH

P

CO

P

RU

B

MY

R

CLP

PE

N

THB

TRY

IDR

BR

L

ZAR

HU

F

RO

N

CZKPLN

Rates FX Cap Gains Total

-15%

-10%

-5%

0%

5%

10%

15%

INR

KRW

MXN

CN

Y

IDR

CLP

CO

P

ILS

THB

RU

B

TRY

PEN

MYRBR

L

ZAR

PLN

RO

N

HU

F

PHP

CZK

FX Cap Gains Carry Total


Exhibit 2 Sovereign Credit Return Base Case Forecasts, 4Q14

-20%

-15%

-10%

-5%

0%

5%

10%

HU

N

IND

O

UKRLI

T

CR

O

SOA

F

POL

RU

S

MEX

CO

L

CH

I

TUR

K

PER

VEN

Z

BRA

UST Yield Impact Carry Spread Impact Total



26


Exhibit 3 Local Rates 4Q14 5Y Base Case Forecast – Forward

-50

-25

0

25

50

75

100

INR

IDR

PEN PLN

BR

L

KR

W

RU

B

ZAR

MX

N

PH

P

THB

CLP ILS

NG

N

TRY

HU

F

RO

N

CZK

MY

R

CN

Y

CO

P

Source: Morgan Stanley Research forecasts, Bloomberg

Exhibit 4 EMFX 4Q14 Base Case Forecast – Forward

-5%0%5%

10%15%20%

AR

S

MX

N

INR

KR

W

PLN

HU

F

IDR

CN

Y

RO

N

CO

P

CLP

TRY

ILS

CZK

RU

B

THB

MY

R

ZAR

HK

D

BR

L

PEN

TWD

SG

D

PH

P


Exhibit 5 Credit 4Q13 10Y Spread Base Case Forecast – Forward Spread

020406080

100TU

RK

ME

X

PO

L

HU

N

SO

AFLIT

IND

RU

S

CO

L

CH

I

PER

BR

A



27


EM Strategy and Economics Teams EM Fixed Income and Foreign Exchange Strategy

New York Rashique Rahman Team Head, EM Macro Strategy [email protected] +1 212 761 6533 Juha Seppala Global FXEM Quantitative Strategist [email protected] +1 212 761 1949 Felipe Hernandez LatAm FX Strategy [email protected] +1 212 296 4996 Robert Habib EM Strategy [email protected] +1 212 761 1875 Vandit Shah FX & EM Strategy [email protected] +1 212 761 1890

London Paolo Batori, CFA European Head of EM Strategy [email protected] +44 (0)20 7677 7971

& Global Head of Sovereign Credit Strategy Vanessa Barrett Chief EM Credit Strategist [email protected] +44 (0)20 7677 9569 Mihail Bozinov CEEMEA Rates Strategy [email protected] +44 (0)20 7677 1150 James Lord Global EM Macro Strategy [email protected] +44 (0)20 7677 3254 +44 ( Kristina Obrtacova EM Corporate Credit Strategy [email protected] +44 (0)20 7677 7597 Robert Tancsa Sovereign Credit Strategy [email protected] +44 (0)20 7677 6671 Simon Waever Credit Relative Value, EM Analytics [email protected] +44 (0)20 7425 1640 Meena Bassily CEEMEA Macro Strategy [email protected] +44 (0)20 7677 0031

Hong Kong Viktor Hjort Head of AXJ Credit Strategy/ [email protected] +852 2848 7479

Fixed Income Research Nishant Sood AXJ Credit Strategy [email protected] +852 2239 1597 Gaurav Singhal AXJ Credit Strategy [email protected] +852 2239 7300 Geoffrey Kendrick AXJ FX & Rates Strategy [email protected] +852 2239 7399 Kewei Yang AXJ Rates Strategy [email protected] +852 3963 0562 Kritika Kashyap AXJ Rates Strategy [email protected] +852 2239 7179 EM Economics Manoj Pradhan Global [email protected] +44 (0)20 7425 3805 Tevfik Aksoy Head of CEEMEA Economics [email protected] +44 (0)20 7677 6917 / Turkey, Israel Michael Kafe South Africa, Nigeria, Ghana, Kenya [email protected] +27 11 587 0806 Andrea Masia South Africa, Nigeria, Kenya [email protected] +27 11 282 1593 Pasquale Diana Poland, Hungary, Czech, Romania [email protected] +44 (0)20 7677 4183 Jacob Nell Russia, Kazakhstan, Ukraine, Belarus [email protected] +7 495 287 2134 Alina Slyusarchuk Russia, Kazakhstan, Ukraine, Georgia [email protected] +44 (0)20 7677 6869 Gray Newman LatAm [email protected] +1 212 761-6510 Luis Arcentales Chile, Mexico [email protected] +1 212 761-4913 Arthur Carvalho Brazil [email protected] +55 11 3048 6272 Daniel Volberg Argentina, Colombia, Peru, Venezuela [email protected] +1 212 761-0124 Helen Qiao China [email protected] +852 2848 6511 Sharon Lam Korea, Taiwan [email protected] +852 2848 8927 Yuande Zhu China, Hong Kong [email protected] +852 2239 7820 Yin Zhang China [email protected] +852 2239 7818 Jason Liu Korea, Taiwan [email protected] +852 2848 6882 Chetan Ahya Asia ex-Japan, India [email protected] +852 2239 7812 Deyi Tan ASEAN [email protected] +65 6834 6703 Zhixiang Su ASEAN [email protected] +65 6834 6739 Derrick Kam Asia ex-Japan, Hong Kong [email protected] +852 2239 7826 Jenny Zheng Asia ex-Japan [email protected] +852 3963 4015 Upasana Chachra India [email protected] +91 22 6118 2246 Morgan Stanley entities: London/South Africa – Morgan Stanley & Co. International plc; RMB Morgan Stanley (Proprietary) Limited; New York – Morgan Stanley & Co. LLC; Hong Kong/Shanghai – Morgan Stanley Asia Limited.; Singapore – Morgan Stanley Asia (Singapore) Pte.; Japan – Morgan Stanley MUFG Securities Co., Ltd.; India – Morgan Stanley India Company Private Limited; Brazil – Morgan Stanley C.T.V.M. S.A.; Russia – OOO Morgan Stanley Bank.

mailto:[email protected]








































28


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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: Rashique Rahman 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 Within the last 12 months, Morgan Stanley managed or co-managed a public offering (or 144A offering) of securities of FEDERATIVE REPUBLIC OF BRAZIL, PEOPLE'S REPUBLIC OF CHINA, UNITED MEXICAN STATES. Within the last 12 months, Morgan Stanley has received compensation for investment banking services from FEDERATIVE REPUBLIC OF BRAZIL, PEOPLE'S REPUBLIC OF CHINA, RUSSIAN FEDERATION, UKRAINE, UNITED MEXICAN STATES. In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from ARAB REPUBLIC OF EGYPT, ARGENTINE REPUBLIC, CZECH REPUBLIC, FEDERAL REPUBLIC OF NIGERIA, FEDERATIVE REPUBLIC OF BRAZIL, GOVERNMENT OF MALAYSIA, HUNGARY, PEOPLE'S REPUBLIC OF CHINA, REPUBLIC OF CHILE, REPUBLIC OF COLOMBIA, REPUBLIC OF CROATIA, REPUBLIC OF INDONESIA, REPUBLIC OF PERU, REPUBLIC OF POLAND, REPUBLIC OF SOUTH AFRICA, REPUBLIC OF TURKEY, ROMANIA, RUSSIAN FEDERATION, UKRAINE, UNITED MEXICAN STATES. Within the last 12 months, Morgan Stanley has received compensation for products and services other than investment banking services from ARAB REPUBLIC OF EGYPT, CZECH REPUBLIC, FEDERATIVE REPUBLIC OF BRAZIL, GOVERNMENT OF MALAYSIA, PEOPLE'S REPUBLIC OF CHINA, REPUBLIC OF INDONESIA, REPUBLIC OF POLAND, RUSSIAN FEDERATION. 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: ARAB REPUBLIC OF EGYPT, ARGENTINE REPUBLIC, CZECH REPUBLIC, FEDERAL REPUBLIC OF NIGERIA, FEDERATIVE REPUBLIC OF BRAZIL, GOVERNMENT OF MALAYSIA, HUNGARY, PEOPLE'S REPUBLIC OF CHINA, REPUBLIC OF CHILE, REPUBLIC OF COLOMBIA, REPUBLIC OF CROATIA, REPUBLIC OF INDONESIA, REPUBLIC OF PERU, REPUBLIC OF POLAND, REPUBLIC OF SOUTH AFRICA, REPUBLIC OF TURKEY, ROMANIA, RUSSIAN FEDERATION, UKRAINE, UNITED MEXICAN STATES. 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: ARAB REPUBLIC OF EGYPT, CZECH REPUBLIC, FEDERATIVE REPUBLIC OF BRAZIL, GOVERNMENT OF MALAYSIA, HUNGARY, PEOPLE'S REPUBLIC OF CHINA, REPUBLIC OF INDONESIA, REPUBLIC OF POLAND, REPUBLIC OF SOUTH AFRICA, RUSSIAN FEDERATION, STATE OF ISRAEL, UNITED MEXICAN STATES. Morgan Stanley & Co. LLC makes a market in the securities of FEDERATIVE REPUBLIC OF BRAZIL, PEOPLE'S REPUBLIC OF CHINA. 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 November 30, 2013) 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 995 34% 313 38% 31% Equal-weight/Hold 1283 44% 388 47% 30% Not-Rated/Hold 109 4% 26 3% 24% Underweight/Sell 537 18% 99 12% 18% Total 2,924 826 Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months. Analyst Stock Ratings Overweight (O or Over) - The stock's total return is expected to exceed the total return of the relevant country MSCI Index or 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 or Equal) - The stock's total return is expected to be in line with the total return of the relevant country MSCI Index or 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 relevant country MSCI Index or 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 or Under) - The stock's total return is expected to be below the total return of the relevant country MSCI Index or the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months. Analyst Industry Views Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below. In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below. Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below. Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index. Important Disclosures for Morgan Stanley Smith Barney LLC Customers 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 ARGENTINE REPUBLIC, BOLIVARIAN REPUBLIC OF VENEZUELA, CZECH REPUBLIC, FEDERAL REPUBLIC OF NIGERIA, FEDERATIVE REPUBLIC OF BRAZIL, GOVERNMENT OF MALAYSIA, HUNGARY, PEOPLE'S REPUBLIC OF CHINA, REPUBLIC OF CHILE, REPUBLIC OF COLOMBIA, REPUBLIC OF CROATIA, REPUBLIC OF INDIA, REPUBLIC OF INDONESIA, REPUBLIC OF KAZAKHSTAN, REPUBLIC OF KOREA, REPUBLIC OF LITHUANIA, REPUBLIC OF PERU, REPUBLIC OF POLAND, REPUBLIC OF SOUTH AFRICA, REPUBLIC OF THE PHILIPPINES, REPUBLIC OF TURKEY, ROMANIA, RUSSIAN FEDERATION, STATE OF ISRAEL, THAILAND, UKRAINE, UNITED MEXICAN STATES. Morgan Stanley Hong Kong Securities Limited is the liquidity provider/market maker for securities of PEOPLE'S REPUBLIC OF CHINA listed on the Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website: http://www.hkex.com.hk. 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. This may be the result of differing time horizons, methodologies, market events, or other factors. For all research available on a particular stock, please contact your sales representative or go to Matrix at http://www.morganstanley.com/matrix. Morgan Stanley Research is provided to our clients through our proprietary research portal on Matrix and also distributed electronically by Morgan Stanley to clients. 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In addition you consent to Morgan Stanley processing your personal data and using cookies in accordance with our Privacy Policy and our Global Cookies Policy (http://www.morganstanley.com/privacy_pledge.html), including for the purposes of setting your preferences and to collect readership data so that we can deliver better and more personalised service and products to you. To find out more information about how Morgan Stanley processes personal data, how we use cookies and how to reject cookies see our Privacy Policy and our Global Cookies Policy (http://www.morganstanley.com/privacy_pledge.html). If you do not agree to our Terms of Use and/or if you do not wish to provide your consent to Morgan Stanley processing of your personal data or using cookies please do not access our research. Morgan Stanley Research does not provide individually tailored investment advice. Morgan Stanley Research has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. The securities, instruments, or strategies discussed in Morgan Stanley Research may not be suitable for all investors, and certain investors may not be eligible to purchase or participate in some or all of them. Morgan Stanley Research is not an offer to buy or sell any security/instrument or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities/instruments transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. If provided, and unless otherwise stated, the closing price on the cover page is that of the primary exchange for the subject company's securities/instruments. The fixed income research analysts, strategists or economists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality, accuracy and value of research, firm profitability or revenues (which include fixed income trading and capital markets


30


profitability or revenues), client feedback and competitive factors. Fixed Income Research analysts', strategists' or economists' compensation is not linked to investment banking or capital markets transactions performed by Morgan Stanley or the profitability or revenues of particular trading desks. Morgan Stanley Research is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or to participate in any particular trading strategy. The "Important US Regulatory Disclosures on Subject Companies" section in Morgan Stanley Research lists all companies mentioned where Morgan Stanley owns 1% or more of a class of common equity securities of the companies. For all other companies mentioned in Morgan Stanley Research, Morgan Stanley may have an investment of less than 1% in securities/instruments or derivatives of securities/instruments of companies and may trade them in ways different from those discussed in Morgan Stanley Research. 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