MORGAN STANLEY RESEARCH

November 29, 2010

European Strategy

2011 Scenarios Under our base case scenario we would recommend investors
maintain an overweight position in commodities and selectively
invest in Financials (predominantly diversified financials and
Balancing it all up – equities to go higher in 2011 but
insurance) and stocks with good growth prospects. Stocks with
prepare for a rough ride
a high and secure dividend yield are likely to remain in demand,
When we look across the macro backdrop described above,
we think, especially where there is decent dividend growth. On
there are a number of important cross-currents at work next
the assumption that sovereign fears remain a regular backdrop
year that provide both positive and negative risk events.
to 2011, we think Banks are likely to remain under pressure
Notwithstanding a higher level of uncertainty than normal we
and we would also avoid stocks with little growth, especially
believe equities will rise next year, although returns are likely to
those in sectors such as Utilities and Pharmaceuticals.
be volatile and, ultimately, no more than the underlying rate of
Evidence of more significant monetary tightening in EM would
EPS growth. Below we detail our main bull, base and bear case
likely put pressure on Consumer Discretionary stocks also.
assumptions along with the key indicators to watch and
relevant investment implications. As we move through the next
BULL CASE = ‘liquidity-driven equity chase’:
year we think it likely that the stock market will flirt with at least
MSCI Europe index target = 1410, implying 25% upside
two, if not three, of these scenarios at one time or another.
Under our bull case we look for the global economy to surprise
on the upside as the authorities leave fiscal policy unchanged
BASE CASE = ‘reasonable growth, reasonable value’:
while global real interest rates remain highly accommodative/
MSCI Europe index target = 1250, implying 11% upside
negative. Although we assume EM central banks raise rates in
For our base case we adopt Morgan Stanley’s economic
reaction to rising inflation, they do not tighten meaningfully in
forecasts as detailed earlier. In short, reasonable global GDP
real terms for fear of encouraging excessive FX inflows and
growth should drive double-digit profit growth in an asset class
decreasing their global competitiveness. In the West, we
that offers reasonable value, particularly against alternatives.
assume that problems in peripheral Europe are relatively
Despite a plethora of possible risk events, we assume
contained yet have the added benefit of keeping the ECB on
pragmatism wins out on the global stage. In particular, we
hold despite strong growth in other parts of the euro zone. We
suspect that the European authorities will, after no little asset
also look for the Fed to enact QE2 fully, as currently proscribed.
price volatility and gnashing of teeth, ultimately move to
Inflation pressures rise modestly in EM and, although we only
introduce a more comprehensive, longer-lasting solution to
get a modest uptick in inflation in DM, it is evident that deflation
Europe’s sovereign and financial debt problems (probably QE).
risks are receding fast. A renewed focus on inflation creates a
meaningful shift in asset allocation, with investors keen to
With equity markets around fair value currently, in our opinion,
rotate out of nominal assets (cash and bonds) and into real
we look for stocks to move broadly in line with our expectations
assets (equities, commodities and real estate).
for 2011 EPS growth. Given the structural headwinds that we
face, it is hard to argue for a meaningful re-rating of equities
We set our bull case target for MSCI Europe at 1410. We look
under a base case scenario. We are aware of the positive
for EPS to grow 20% next year and for an asset allocation shift
impact from possible asset allocation flows out of bonds and
out of bonds and into equities to drive a moderate re-rating of
into equities; however, at the same time we are conscious that
1-2 P/E points. Within our MTI framework we arrive at our bull
fund flows are highly fickle and that such ‘liquidity’ arguments
case target by using the following assumptions: 4% bond yields,
are hard to quantify. Consequently we would rather incorporate
short rates at 1.25%, CPI at 2.5%, EPS growth of 20% in 2011
this angle into our bull case.
and CVI at 0.25 (this has tended to mark the top of the range in
recent times). Under our bull case we would advise investors to
We set our base case target for MSCI Europe at 1250. With the
look to buy Financials, commodities and stocks with high
market already at fair value (given a 12-month forward P/E for
pension deficits (where a combination of rising equity prices
MSCI Europe of close to 11 versus our assumed fair value
and higher bond yields should quickly reduce funding deficits.
range of 10-12), we set our target broadly in line with the
Defensive stocks and those with high and secure dividend
growth in EPS we expect next year. Within our MTI framework
yields are likely to underperform.
we arrive at our base case target by using the following
assumptions: 4% bond yields, short rates at 1.25%, CPI at
Key indicators include continued strength in key global
2.5%, EPS growth of 12% in 2011 and CVI at 0 (fair value). Our
economic lead indicators; slow pace of EM rate hikes; and fund
base case target implies a 2012 P/E of 11.4.
flows out of bonds and into equities (Exhibit 36).

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 MORGAN STANLEY RESEARCH

November 29, 2010

European Strategy

BEAR CASE = ‘double dip and/or sovereign strife’ Exhibit 37

MSCI Europe index target = 700, implying 38% downside Sovereign CDS – Spain
A bear case outcome for European stocks would likely follow 350

one, two or even three not-mutually-exclusive scenarios. In the 300

first, we would look for the economic recovery to run out of

steam (global GDP growth falls below 3-3.5%), due perhaps to 250

the removal of economic stimuli or the impact of higher input

200
prices depressing disposable income. Our second scenario
envisages a contagion of sovereign debt fears into core Europe 150

and even the US, with a higher cost of capital weighing heavily
100
on growth. Third, in an environment of weak economic growth
and ongoing de-leveraging pressures in DM, we could see an 50

outbreak of trade frictions and/or currency disputes that

0
threaten to undermine the performance of the global economy. Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10

Source: Bloomberg, Morgan Stanley Research

We set our bear case target for MSCI Europe at 700. With so
many permutations setting a bear case target is difficult;
however, we think it is reasonable to assume that markets
could fall to a Shiller P/E of 10 or less, which would imply c.38%
downside from today. Within our MTI framework we arrive at
our bear case target by using the following assumptions:
2.75% bond yields, short rates at 1%, CPI at 1%, EPS growth
of -20% in 2011 and CVI at -2.
Under our bear case scenario we would recommend investors
buy defensive stocks with low economic sensitivity (e.g.
pharmaceuticals, telecoms) and stocks with a high and secure
dividend yield. Commodities, industrials and financials would
suffer the worst performance under this scenario, we think.
Exhibit 38
MSCI Europe Index target scenarios
Bull Case 'Liquidity driven equity chase': MSCI Europe 1,410 (25% upside)
Bond yields of 4.0%, short rates at 1.25%, CPI at 2.5% and EPS growth of 20% in 2011.
Using a CVI value of 0.25 (fair value), this implies a MSCI Europe target of 1410 and an
implied 2011 PE of 12.9.
Base Case 'Reasonable growth, reasonable value': MSCI Europe 1,250 (11% upside)
Our base case assumes bond yields of 4%, short rates at 1.25%, CPI at 2.5%, and EPS
growth of 12% in 2011. Using a CVI value of 0 (fair value), this implies a MSCI Europe
target of 1250 and an implied PE of 12.2 on 2011 EPS and 11.4 on 2012 EPS.
Bear Case 'Double-dip and/or sovereign strife': MSCI Europe 700 (38% downside)
Bond yields of 2.75%, 3M rates of 1% and headline CPI of 1.25%. EPS falls 20% in 2011.
Using a CVI value of -2, this implies a MSCI Europe target of 700 and an implied 2011 PE
of 9.5. In this scenario the European Shiller PE would fall to 8.3.
Source: MSCI, Morgan Stanley Research
Exhibit 39
Risk-reward: MSCI Europe Index target scenarios
1,500

Bull 1,410 (+25%)

1,400
Key indicators include a rollover in key global economic lead
1,300
indicators; widespread introduction of tariffs and capital Base 1,250 (+11%)
1,200
controls; and evidence of further contagion of sovereign fears
within Europe – watch for any significant rise in Spanish CDS 1,100

(Exhibit 37). 1,000

Exhibit 36
900
Under our bull case we’d expect to see investors
800
selling bonds and buying stocks
700 Bear 700 (-38%)

10
600
Nov-08 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11
5
Source: MSCI, Datastream, Morgan Stanley Research estimates

-5

-10

-15 Equity Flows

4 Week Avg
-20
May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10

Source: ICI, Morgan Stanley Research

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 MORGAN STANLEY RESEARCH

November 29, 2010

European Strategy

Exhibit 40
Investment themes for 2011 Commodity price inflation is running at over 60%Y
120
1) Emerging inflation risks
100

YoY % change in CRB Spot Commodity Index

We have written about the prospect of higher inflation a
number of times in recent weeks (for example, How to play the 80

emerging inflation theme, November 15). To summarise, we 60

believe that 2011 will see higher inflation in EM coupled with a 40

trough in inflation in DM (especially the US). Inflation pressures 20

will be predominantly due to higher commodity and input prices
0
and consequently be supply-driven rather than the more
traditional demand-driven inflationary pressures witnessed in -20

DM over the last 30 years or so. We identify three main -40

investment implications of rising inflation pressures: -60

Nov 90 Nov 92 Nov 94 Nov 96 Nov 98 Nov 00 Nov 02 Nov 04 Nov 06 Nov 08 Nov 10

1 – Investors are likely to look increasingly to switch out of Source: Datastream, CRB, Morgan Stanley Research
nominal assets such as bonds and cash and into real assets
such as equities, commodities and real estate. In terms of the Exhibit 41

latter we’d recommend real estate in countries with the highest Correlation of European sectors to commodity prices
European Sector correlation to changes in CRB commodity index

nominal growth and/or lowest real bond yields such as 0.60

0.50
Germany, Scandinavia and the UK. (Note that our Real Estate
0.40
team have recently upgraded their view on the sector due
0.30
partly to this theme – see their report Upgrading to attractive,
0.20
November 19.) 0.10

0.00

2 – Equity investors should overweight stocks with good pricing -0.10

power such as mining, oil services and chemicals while -0.20

diversified financials and real estate should also do well if we -0.30

see commensurate asset price inflation. If rising input costs do lS y -0.40

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sectors with CPI-linked pricing such as regulated utilities,

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motorways, airports and software (where maintenance

revenues are often inflation-linked).
3 – At the stock level we have created two baskets to allow
investors to play the theme of higher input costs and related
pricing power. We recommend investors go long/overweight
our basket of pricing power winners (the Bloomberg code is
Source: Datastream, CRB, Morgan Stanley Research
Exhibit 42
Stocks with high pricing power have consistently
outperformed stocks with low pricing power
135
130
MS Pricing Power Winners vs Losers Rel Perf

MSSTPPWW) and short our basket of pricing power losers

(MSSTPPWL). As illustrated in Exhibit 42, the former has 125

consistently outperformed the latter over the last two years. 120

115

In terms of relative pricing power in general, our analysis also 110

suggests the following sector pair trades: 1) OW premium
105
automakers and tyres versus UW mass-market autos; 2) OW
software versus UW technology hardware; 3) OW Food Retail 100

versus Non-food Retail; and 4) OW Beverages & Tobacco 95

versus Food Producers & HPC. 90

Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10

Source: Bloomberg, Morgan Stanley Research

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 MORGAN STANLEY RESEARCH

November 29, 2010

European Strategy

2) Gaining exposure to higher bond yields
Given their low starting point, we believe even a moderate
economic growth environment coupled with a modest uptick in
inflation would be enough to drive bond yields higher. Investors
should not expect too significant a rise in bond yields as the
growth outlook remains fragile and monetary authorities are
likely to try to cap any sizeable rise to prevent it from derailing
the recovery. In terms of the main beneficiaries of higher bond
yields, Exhibit 43 ranks sectors by their correlation to changes
in 10-year Bund prices over the last two years. As illustrated,
the sectors most likely to benefit from higher bond yields would
be commodities, financials (insurance via reduced pressure on
their guaranteed products and banks for their exposure to a
steeper yield curve) and industrials; the main losers have
tended to be the defensives. A rally in stocks coupled with
higher bond yields would also likely be very positive for stocks
with large pension fund deficits.
Note that higher bond yields driven by sovereign solvency
concerns rather than a higher growth/inflation backdrop would
have somewhat different implications. In particular, we would
3) Reliable growth theme remains compelling
Given that macro concerns are likely to remain a feature of the
European landscape for the foreseeable future, we believe
European investors will continue to place a premium on stocks
that offer a consistent and defensive growth profile. In
particular, we’d highlight our reliable growth strategy as a key
way for investors to play this theme. As illustrated in Exhibits
44-45, despite wider macro concerns this basket currently
trades at a discount to the overall market on trailing dividend
yield and is just in line with its average valuation premium on a
12-month forward P/E basis. Exhibit 47 details the current
constituents of our reliable growth screen. We would highlight
that the following stocks are also constituents of our European
Model Portfolio: Reckitt Benckiser, Sanofi-aventis, Imperial
Tobacco, Saipem, BAT, AstraZeneca and Linde.
Exhibit 44
Reliable growers still offer good value – today’s 18%
premium to market on N12M P/E compares to
long-run average premium of 15%
30 50

expect financials to underperform commodity-related sectors 40

25
given the latter’s exposure to a better structural growth story in
30
Asia/EM. If bond yields do rise due to sovereign solvency
20
concerns, we would expect our reliable growth basket to 20

outperform as investors chase defensive stocks that also have 15 10

some growth characteristics.
0
10
Exhibit 43
-10
Sector correlations to Bund prices – lowest sectors 5
tend to perform best if bond yields rise N12M PE
-20

Correlation (%) % Premium / Discount to MSCI Europe (RHS)

0 -30
2Y (Wkly) 10Y (Mthly)
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Utilities 12 28
Food Beverage & Tobacco 33 28 Source: MSCI, IBES, Datastream, Morgan Stanley Research
Telecommunication Services 40 27
Food & Staples Retailing 27 26
Pharmaceuticals Biotechnology & Life Sciences 43 19 Exhibit 45
Media
Retailing
33
14
18
11
Reliable growers yield more than the market
Household & Personal Products 35 10 6 30
Real Estate -28 7
Consumer Services 8 7 Dividend Yield % 20
Software & Services 28 4 % Premium / Discount to MSCI Europe (RHS)
5
Commercial & Professional Services 22 3 10
Health Care Equipment & Services 45 2
Energy -6 -1 0
4
Transportation 2 -1
-10
Technology Hardware & Equipment 7 -1
Semiconductors & Semiconductor Equipment -6 -15
3 -20
Insurance -16 -16
Banks -33 -17 -30
Consumer Durables & Apparel -13 -18
2
Automobiles & Components -24 -21 -40
Capital Goods -14 -24
Diversified Financials -31 -26 -50
1
Materials -38 -26
-60
Source: MSCI, Datastream, Morgan Stanley Research
0 -70
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Source: MSCI, Datastream, Morgan Stanley Research

16