Morgan Stanley - What If the Euro Overshoots

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					                                                               MORGAN                                         STANLEY                      RESEARCH
                                                               EUROPE


                                                               Morgan Stanley & Co. International                                    Elga Bartsch
                                                               plc+
                                                                                                                                     Elga.Bartsch@morganstanley.com
                                                                                                                                     +44 (0)20 7425 5434

                                                                                                                                     Tomasz Pietrzak
                                                                                                                                     Graham Secker
                                                                                                                                     Graham.Secker@morganstanley.com
                                                                                                                                     +44 (0)20 7425 6188
February 4, 2013
                                                                                                                                     Matthew Garman, CFA

Strategy and Economics                                                                                                               Ian Stannard
                                                                                                                                     Ian.Stannard@morganstanley.com
                                                                                                                                     +44 (0)20 7677 2985

What If the Euro Overshoots?
In this note, we assess the implications of a EUR              Traditionally a stronger EUR implied relative
overshoot. A material EUR overshoot could derail the           underperformance of European equities
tentative stabilisation in economic activity and the                                      30                                    EURUSD YoY % (positive reading = EUR appreciation)         40


ongoing recovery in risk markets. A key policy




                                                                                                                                                                                                 1yr % ch in MSCI US vs MSCI Europe ex UK
                                                                                                                                                                                           30
                                                                                          20
implication of a material EUR overshoot would be that
                                                                                                                                                                                           20




                                                                 1yr % ch in EUR vs USD
the debate about ECB rate cuts would be reopened. In                                      10

addition, a much stronger EUR could also challenge the                                                                                                                                     10
                                                                                           0
positive sentiment vis-a-vis the periphery.                                                                                                                                                0

                                                                                          -10
                                                                                                                                                                                           -10
Increasing possibility of a EUR overshoot:
We have warned about the possibility of EURUSD                                            -20
                                                                                                                                                                                           -20
                                                                                                                                          MSCI US vs MSCI Eur ex UK YoY % - rhs
overshooting our near-term 1.36 target for a while. Now                                   -30                                                                                              -30
there is an increasing possibility of EURUSD                                                Feb-94   Feb-96   Feb-98   Feb-00    Feb-02     Feb-04   Feb-06   Feb-08   Feb-10     Feb-12


overshooting and breaking above 1.40. Valuation                Source: MSCI, Datastream, Morgan Stanley Research
models, which still put EURUSD below fair value,
suggest there is still scope for EURUSD to extend gains.
Our year-end target remains unchanged at 1.26 though.

Would introduce risks to the euro area recovery:
A 10% appreciation in the EUR reduces euro area GDP
by ~ 0.5% in the first year. A simulation of the impact of a
permanent increase of the trade-weighted exchange
rate of the EUR by 10% relative to our current baseline
forecasts of -0.5% GDP growth this year shows that a
marked rise in the EUR would likely derail the H2
recovery. Exports, capex and corporate profits would
likely be hit hardest, consumer spending the least.

Navigating equity markets when the EUR is rising:
Historically, a stronger EUR has been negative for
relative equity market performance and we estimate that
every 10% move in EUR impacts EPS by 3%. At the
sector level a stronger EUR tends to favour Utilities,
Retail, Real Estate, Food & Beverages and Construction
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                                                                    MORGAN       STANLEY        RESEARCH

                                                                    February 4, 2013
                                                                    Strategy and Economics




What If the Euro Overshoots? Summary and Conclusions
In this note, we assess the implications of a material              differentiated products, matters and so does the size of the
overshoot of the EUR on Euro Area economies and                     export market. Together with the rate of capacity utilisation it
European equity markets. A material EUR overshoot could             determines exporters’ pricing strategy where exporters could
derail the tentative stabilisation in economic activity and the     decide to absorb a stronger EUR in their profit margins and
recovery in market sentiment. A key policy implication of a         protect their market share, notably in large markets such as the
material EUR overshoot would be that the debate about a ECB         US. Next to direct exports, foreign affiliate sales of euro area
rate reduction would be reopened, up to and including a             companies abroad are another transmission channel for
deposit rate cut. In addition, a much stronger EUR could also       currency moves. Foreign affiliate sales (FAS) account for a
challenge the positive market sentiment vis-a-vis the periphery     significant multiple of the direct exports, especially in the US.
and the structural improvements in export performance there.        The FX impact on export demand, import competition and
                                                                    corporate profits also affects the wider euro area economy.
Our FX strategy team has cautioned about the possibility of the     The fall in output is partially offset by a fall in inflation (as
EUR overshooting their near-term 1.36 target vs. the USD for a      imports get cheaper and unemployment starts to rise). Initially,
while (see FX Pulse: EUR Overshoot, January 24, 2013). The          consumer spending is sheltered via lower domestic inflation
FX team believe there is now an increasing possibility of           and higher affordability of imported goods while investment
EURUSD overshooting to the upside and breaking above 1.40.          spending takes a serious hit. Overall, a 10% appreciation in
Their valuation models, which would still put EURUSD below          the euro’s external value reduces GDP by ~ 0.5% in the first
fair value, suggest there is still scope for EURUSD to extend       year. Hence, a material EUR overshoot could tilt the debate on
gains. In addition, Japanese investors are leading the way with     the ECB Governing Council back towards rate cuts.
a reallocation into EUR as the BoJ’s easing measures create
JPY liquidity that will be seeking higher returns overseas. As      Equity strategy implications
traditional higher yielders such as AUD no longer generate the      We would summarise the equity implications of a stronger Euro
required returns, our FX experts believe that attention will be     as follows:
returning to the EUR, and peripheral EMU. In terms of currency
moves, EURJPY has been leading the way. But as EURUSD               - Over time, a stronger EUR is usually negative for the relative
closes the gap this could cause a EURUSD overshoot to 1.40.         performance of European equities (in local currency terms).

Normally, a short-lived EUR rally would not make a big              - We estimate that a 10% rise in trade-weighted EUR would
difference for the euro area growth outlook. But at the current     hurt European EPS growth by c. 3%.
juncture, the impact might be more pronounced, given only a
tentative stabilisation in economic indicators, the unresolved      - Implications of EUR moves on sector performance can be
issues regarding the EUR’s institutional underpinnings and the      inconsistent. In general, a stronger EUR tends to favour
ongoing rebalancing of the euro area. While a mildly stronger       Utilities, Retail, Real Estate, Food & Beverages and
EUR might not necessarily be an issue for the euro area as a        Construction & Materials. The relative laggards are often
whole, some countries already face strong competitive               Technology, Financials, Autos – we also expect Capital Goods
pressure and don’t have a domestic demand cushion to offset         & Healthcare to be at risk of underperforming.
deteriorating export demand as austerity continues to bite. This
holds in particular for Greece and Italy and to lesser extent for   - On page 19 we provide a list of stocks that are potentially hurt
France, Portugal and Spain.                                         by a stronger euro based on analysis of geographical revenue
                                                                    exposure and share price correlation to moves in EUR. On
From an economic point of view, the impact of a stronger EUR        page 20 we details a list of stocks with relatively high revenue
is determined by the pattern of international trade, on the share   exposure to Japan.
of domestic production that is exported and on the degree of
import competition, as well as the extent to which imported         - MSCI UK tends to underperform MSCI EMU in periods of
inputs are used in domestic production. The higher the share of     GBP weakness. Relative sector beneficiaries of a weaker GBP
imported inputs contained in goods exported, the lower the          are Personal & Household Goods, Healthcare and Chemicals.
domestic value added negatively affected. In addition,
exporters’ pricing power, which tends be to higher for




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                                                                   February 4, 2013
                                                                   Strategy and Economics




FX Strategy: Rising Risks of EUR Overshoot
Morgan Stanley & Co.   Ian Stannard – FX Strategy                  the JPY playing a significant role in Japan’s policy initiative.
International plc      Ian.Stannard@morganstanley.com
                                                                   Indeed, we have found that there is a close correlation between
                                                                   Japanese inflation and the JPY with a lag, suggesting that JPY
•     We believe there is now an increasing possibility of         weakness has a strong tendency to feed through in to inflation
      EURUSD overshooting to the upside                            and inflation expectations. However, to achieve the
                                                                   newly-adopted inflation target of 2%, relying on the exchange
•     Our valuation models suggest there is still scope for        rate alone will require further significant JPY weakness. We
      EURUSD to extend gains                                       have one of the most bullish USDJPY forecasts in the market,
                                                                   anticipating 95.00 for this quarter. However, even this
•     Japanese investors are leading the way with a reallocation   projection is appears to be moderate in the current
      into EUR, in our view…                                       environment.

•     …as the BoJ easing measures create JPY liquidity             We anticipate JPY weakness having significant implications for
      seeking higher returns overseas                              global financial markets, even changing the behaviour of
                                                                   currencies. Indeed, there is already strong evidence to suggest
•     Traditional higher yielders such as AUD no longer            that the EUR is at the forefront of these changing market
      generated the required returns…                              dynamics, which could drive the EUR into overshooting
                                                                   territory as a result.
•     …suggesting attention is returning to EUR, and peripheral
      EMU                                                          EURJPY a leading indicator
                                                                   Indeed, we would suggest that EURJPY is acting as a leading
•     EURJPY has been leading the way, but we expect               indicator for broader EUR gains, even having the potential to
      EURUSD to close the gap…                                     drive EURUSD higher, as JPY weakness generates a change
                                                                   in Japanese and global investor behaviour, resulting in sizable
•     …opening the way for an EURUSD overshoot to 1.40             portfolio shifts.

EUR upside potential                                               Exhibit 1
Despite strong gains since the middle of last year, and even the   EURUSD at fair value
accelerated pace of appreciation in the past couple of months,
the EUR remains relative moderately valued against the USD           1.60
                                                                                                          EURUSD
and on many crosses, according to our models, suggesting             1.50
that there remains plenty of potential for further gains. Our
                                                                     1.40
traditional PPP models (see Exhibit 1) suggest that the EUR
has only just returned to fair value (MS PPP fair value estimate     1.30
                                                                                 EURUSD PPP
for EURUSD currently 1.33) after a period of significant under       1.20
valuation, while our short run misalignment models show that         1.10
the EUR is still undervalued in many cases, even against the
                                                                     1.00
USD. On a trade-weighted basis the EUR also remains below
its long run average. Hence, we believe that there is an             0.90

increasing risk that EURUSD overshoots on the upside,                0.80
exceeding our 1.3600 forecast, with the 1.40 area looking               Mar-98       Mar-01          Mar-04   Mar-07   Mar-10   Mar-13

increasingly achievable.                                           Source: Morgan Stanley Research


EUR gains are being driven to a large extent by developments       With the JPY weakening and Japanese investors’ currency
in Japan, in our view, where the scale and pace of policy          expectations changing, there is likely to be a greater tendency
implementation, both monetary and fiscal by the new Abe-led        for Japanese investors to seek higher returns overseas on a
government is exceeding market expectations. This dynamic          currency unhedged basis. The Japanese flow data suggests
has been highlighted by the sharp rise in EURJPY as a result of    that this is already happening. We have highlighted in the past
                                                                   the increasing use of the JPY as a funding currency, especially



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                                                                     February 4, 2013
                                                                     Strategy and Economics




for AXJ strategies, as implied by the sharp money market             EUR – Investment destination
outflows from Japan and the increased inverse correlation            The ECB’s OMT has stabilized peripheral EMU asset markets
between JPY and the performance of Asian equity markets.             and reduced risk premia. This is evident when analysing
                                                                     risk-adjusted yields. Risk-adjusted yields are one of our
However, we now believe that outflows from Japan have                favoured indicators for the EUR and have proved to be a
broadened to larger scale portfolio shifts. But, examination of      successful guide, even when other more traditional indicators
the portfolio flow data finds that flows have not been heading to    broke down during periods of heightened market volatility. This
the traditional higher yielding currencies in the G10 normally       has continued to be the case, with the EUR risk-adjusted yield
favoured by Japanese investors. Indeed, portfolio inflows to the     having rebounded from its lows mid-last year, and proving to
AUD have in fact been slowing down. We believe this is a result      be a good leading indicator for EURUSD. The EU-US
of the global decline in yields, which has left many of the          risk-adjusted yield differential has also been an equally
traditional higher yielding currencies unable to offer the returns   effective indicator for currency markets and is currently
they have historically generated. Hence, the liquidity being         pointing towards a higher EURUSD (see Exhibit 4).
generated by JPY weakness is now seeking alternative higher
yielders, with the EUR now catching the attention of                 Exhibit 3

international investors.                                             Japanese portfolio flows (12m cumulative)e

Changing investor behaviour
The changing trends in investor behaviour are clearly visible in
the flow data where the Japanese portfolio investment into
EMU is currently running at the fastest pace since 2005 (see
Exhibit 3), while flows into the AUD have slowed to a pace
approaching the recent lows of 2010. This has also changed
the behaviour of EURAUD, which has rebounded strongly over
recent months, breaking the correlation to indicators of risk
appetite, such as the performance of the S&P (see Exhibit 2).

Exhibit 2
EURAUD loosening correlation to risk appetite
                                                                     Source: Haver Analytics and Morgan Stanley Research


                                                                     Hence, the weakness of the JPY is leading a portfolio shift out
                                                                     of the JPY into higher yielding alternatives, with Europe
                                                                     heading the list of investment destinations among the G10,
                                                                     with higher yields at the periphery attracting investors.
                                                                     Furthermore, the recent outperformance of European asset
                                                                     markets has not gone unnoticed by the broader investment
                                                                     community.

                                                                     While Japanese investors appear to have been leading the
                                                                     way in returning to European markets, there is also evidence to
                                                                     suggest that they are not the only ones. Currencies that had
Source: Haver Analytics and Morgan Stanley Research
                                                                     been acting as safe havens to the volatility and uncertainty in
                                                                     Europe are currently underperforming. This suggests that the
While the increased incentive for Japanese portfolio managers        improvement of market conditions at the periphery of Europe is
to invest overseas is driven by the changes in Japanese policy       also leading to an unwinding of safe haven flows with GBP,
in our view, we suggest that European policy changes have            SEK and even CHF coming under pressure as a result. This
develop the conditions for international investors to consider a     suggests that the strong rise in EURJPY is now likely to spill
reallocation to the EUR.                                             over into broader support for the EUR, leading to an overshoot
                                                                     of EURUSD.




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                                                                                    February 4, 2013
                                                                                    Strategy and Economics




Exhibit 4                                                                           Exhibit 5
EURUSD and 5-year risk-adjusted yield spread                                        EURJPY leading EURUSD

 120                                  EUR-USD 5 yr Risk Adjusted Yield       1.50
        bp
 100                                  EURUSD(RHS)
                                                                             1.45
   80
   60
                                                                             1.40
   40
   20                                                                        1.35
    0
                                                                             1.30
  -20
  -40
                                                                             1.25
  -60
  -80                                                                        1.20
    Jan-11           Jul-11          Jan-12          Jul-12         Jan-13

Source: Reuters Ecowin, Morgan Stanley Research                                     Source: Reuters Ecowin, Morgan Stanley Research


EURJPY dragging EURUSD higher                                                       We maintain a bullish EURUSD forecast of 1.3600, but believe
Indeed, EURJPY has been the most significant mover year-to                          an overshoot into the 1.40 area is increasingly possible.
date among the G10 currencies, with gains of 6.5%. While
gains in the EURJPY cross have been driven to a large extent                        Morgan Stanley is acting as sole financial adviser to PSA
by the weakness of the JPY, it must be pointed out that the                         Peugeot Citroen SA ("Peugeot") in relation to their strategic
EUR has been independently strong, making gains on many of                          alliance with General Motors Co., as announced on February
the other crosses and against the USD. However, these EUR                           29, 2012. The proposed acquisition is subject to requisite
gains have been more muted with the EUR only making gains                           regulatory approvals and other customary closing conditions.
of 1.90% year-to-date against the USD.                                              Peugeot has agreed to pay fees to Morgan Stanley for its
                                                                                    financial services that are contingent upon the consummation
Our analysis finds that the correlation between the EURUSD                          of the proposed transaction. Please refer to the notes at the
and EURJPY has remained intact, suggesting that the                                 end of the report.
EURJPY gains are likely to spill over into EURUSD. We note
that the difference in the pace of gains (% year-on-year)
between EURJPY and EURJPY is now at an extreme, with the
gap as large as that seen since 2001. Historically, a divergence
in performance between EURJPY and EURUSD of this
magnitude is only temporary and is usually closed quickly.
Given that we anticipate the JPY weakening trend to be
sustainable as a result of the rapid pace at which the Japanese
authorities are implementing policy changes, we expect
EURJPY gains to continue to push EURUSD higher, opening
the way for a EUR bullish overshoot.




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                                                                     February 4, 2013
                                                                     Strategy and Economics




Divergence of EUR Fair Values in EMU                                 Exhibit 6
                                                                     EURUSD fair value of EMU countries
While our PPP models show that EURUSD has only just
moved back to fair value, at the 1.33 level, following a period of
under-valuation, our analysis of fair value EUR rates for                               Over/Under Valuation              EURUSD Equivalent
                                                                     EURUSD                                                             1.33
individual countries within EMU shows significant divergence.
                                                                     Germany                                     -13.2%                 1.53
For example, we estimate the fair value of the EUR against the
                                                                     Ireland                                      -5.7%                 1.41
USD, for Germany at 1.53, while at the other end of the scale,       Austria                                      -1.5%                 1.35
we estimate the fair value of the EUR for Greece to be just 1.07.    Finland                                       3.8%                 1.28
While there is a wide divergence of fair values within EMU, we       Spain                                         5.4%                 1.26
also find it of interest that with EURUSD currently at our           Portugal                                      7.3%                 1.24
estimate of aggregate fair value, there are only three countries     France                                        7.8%                 1.23
with a fair value above this level, Germany, Ireland and Austria.    Netherlands                                   9.1%                 1.22
The other countries in EMU have much lower fair values,              Belgium                                      12.0%                 1.19
according to our calculations.                                       Italy                                        12.1%                 1.19
                                                                     Greece                                       24.3%                 1.07
                                                                     Source: Haver Analytics, Morgan Stanley Research
Looking at some of the EUR cross rate fair values also reveals
some interesting developments, especially EURJPY, where              The MS PPP fair value estimates are generated from our
the recent sharp decline of the JPY has taken USDJPY above           Purchasing Power Parity (PPP) models, where we use a
our estimate of fair value. We currently estimate EURJPY fair        combination of CPI and PPI price indices to capture relative
value at 111.15, suggesting that the EUR on an aggregate             price differentials. To estimate the fair value of the EUR for
basis is above fair value against the JPY. Moreover, we              individual countries within EMU, we assess the relative
calculate the German EURJPY fair value at 127.65, which is           changes in competitiveness for each country since they joined
being approached.                                                    the EUR. To achieve this we use three measures of
                                                                     competitiveness, relative growth compared to the Eurozone
                                                                     average, relative unit wage costs and relative export growth.




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                                                                               February 4, 2013
                                                                               Strategy and Economics




Economics: What If the Euro Overshoots?
Morgan Stanley & Co.                 Elga Bartsch – European Economics         materialise on the currency front? Well, in typical economist
International plc                    Elga.Bartsch@morganstanley.com
                                     Tomasz Pietrzak                           refrain: “It depends”. Here are the factors on which it depends.
                                     Tomasz.Pietrzak@morganstanley.com
                                                                               Going forward, it matters which FX cross is moving …
•        A 10% rise in the EUR reduces GDP by ~ 0.5% in the first
                                                                               USD is by far the most important currency cross in terms of the
         year. Below we simulate the impact of a 10% increase in
                                                                               euro area’s international competitiveness. This is not just
         EUR relative to our current baseline estimates and find
                                                                               because the US is a key trading partner for the euro area, but
         that it would derail the H2 recovery we are forecasting.
                                                                               also because China has pegged its currency against the USD.
                                                                               On average, ~33% of international trade (excl intra EMU trade)
•        A material EUR overshoot could therefore potentially
                                                                               is affected by EURUSD moves if we take direct exports and
         derail the tentative stabilisation in economic activity and
                                                                               direct imports as well as third-market effects, where euro area
         the recovery in market sentiment in the euro area.
                                                                               exporters compete against dollar-based producers, into
                                                                               consideration. This compares to only ~7% for Japan and ~15%
•        In addition, a much stronger EUR could challenge the
                                                                               for the UK. Within the euro area there are significant country
         positive market sentiment vis-a-vis the periphery and the
                                                                               differences though due to varying export specialisations. The
         structural improvements in competitiveness seen there.
                                                                               countries competing the most with USD bloc are, actually, the
                                                                               Netherlands, Ireland, and Italy where the total USD
•        A key policy implication of a material EUR overshoot
                                                                               based-trade accounts for 40% or more. The countries trading
         would be that the debate about ECB rate reduction would
                                                                               the most with the JPY are the Benelux countries (~8.5%). The
         be reopened, up to and including a deposit rate cut.
                                                                               country facing most GBP competition is also Ireland, where UK
                                                                               trade accounts for 29%.
Exhibit 7
                                                                               Exhibit 8
Euro’s external value close to long-run average                                Trade pattern shows: USD matters more than JPY
115                                                                      115         Weights for 20 main trading
                   Euro: trade weighted index, 1999 Q1 = 100                    90   partners, excluding intra-EMU
                                                                                     trade
                                                                                                                            Trade Weights EMU
                   TWI, smoothed
110                                                                      110    80
                                                                                        UK
                                                                                70      Japan
105                                                                      105
                                                                                        Hong Kong                                                                               28.7

                                                                                60      China                                                                            14.3
                                                                                                                                                                  17.6
100                                                                      100            USA                                                                18.4
                                                                                                                                                    15.9
                                                                                                                              12.1    14.9
             LTA                                                                50                                   12.7                    19.1
                                                                                                                                                                         8.2
                                                                                                             12.5                                                               6.3
                                                                                                                              7.3                   7.3    7.2    8.7    2.2    1.7
    95                                                                   95              9.4       10.8
                                                                                                                                      7.2
                                                                                40                                   7.3
                                                                                                                              1.7            7.4    1.7    1.5    2.0
                                                                                                              7.4                     1.6                                       12.2
                                                                                                                     1.8
                                                                                         6.2       6.1        1.0                            1.8
    90                                                                   90     30       1.8       1.5                                                            17.1   24.8
                                                                                                                                                    18.5
                                                                                                                              21.5    18.8                 22.9
                                                                                                                     18.3
                                                                                                                                             17.9
                                                                                         15.1      17.7      22.5
                                                                                20
    85                                                                   85
                                                                                                                                                                                30.5

                                                                                10                                   16.5     16.3    16.9          19.1          20.6   18.1
                                                                                         14.3                                                14.7          15.0
                                                                                                   11.9      10.4
    80                                                                   80
                                                                                 0
                                                                                         AT         FI       GR      DE       IT     EMU     PT     FR     SP     BE     NT     IE
Source: ECB, Morgan Stanley Research

                                                                               Note that that trade weights represent the global trade structure excluding the intra-EMU trade
Euro’s external value close to long-run average for now                        over the period 2007-09.
                                                                               Source: ECB, Morgan Stanley Research
The starting point is one where the EUR in trade-weighted
terms is broadly in line with its long-term average, both in                   … as well as openness and supply chain integration …
nominal and real terms. This would imply that at face value the                The pattern of international trade is only a first step in
EUR is not excessively strong yet. But these aren’t normal                     assessing the potential exposure of an economy or a sector.
times in the euro area. Instead, on our forecasts, the euro area               Other key factors are the degree of openness, i.e. the share of
is the weakest link amongst the large industrial countries.                    domestic value-added subject to international competition.
Clearly, the euro area is not enjoying any tailwinds on the                    This will depend on the share of production that is exported and
currency side. But, what if serious headwinds start to                         on the degree of import competition, as well as the share of




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                                                                                   February 4, 2013
                                                                                   Strategy and Economics




imported inputs. Increasingly integrated global supply chains                      Exhibit 10

mean that imported inputs are an increasingly important factor                     EURUSD vs. export orders and expectations
in determining the exchange-rate sensitivity. The higher the                        2.0                                   Extra EMU Merchandise Trade                                                       1.7

shared of imported inputs contained in goods exported, the
lower the domestic value added and the higher the potential                         1.0                                                                                                                     1.5

pass-through to the producers of the intermediate inputs.
                                                                                    0.0                                                                                                                     1.3

Exhibit 9
Foreign value-added contained in exports varies                                     -1.0                                                                                                                    1.1

depending on integration into global supply chains
 45                                                                                 -2.0                                                                                                                    0.9
             Foreign Value Added Share of Exports (2009)                    40.4
 40
                                                                                    -3.0                                                                                                                    0.7
                                                                                                   EA17: Industry: Volume of Export Order Books (LHS, std)
                                                                     33.9
 35                                             31.6   32.0   32.3                                 Germany: Ifo Export Expectations (LHS, std)
                                                                                                   EURUSD
 30                                                                                 -4.0                                                                                                                    0.5
                                  25.4   25.7                                           1991              1994             1997                2000      2003          2006           2009          2012
                           24.4
 25                 22.6
                                                                                   Source: Ifo, European Commission, DataStream, Morgan Stanley Research
             18.9
 20   17.9
                                                                                   Exhibit 11
 15                                                                                Export profit margins vary a great deal
 10                                                                                 90     Export profit margin is defined here as the share
                                                                                           of manufacturing gross operating surplus (GOS) in
                                                                                                                                               Export Profit Margins
                                                                                           manufacturing gross value added (GVA). GOS
  5                                                                                        has been estimated by subtracting manufacturing
                                                                                    80     employee compensation from manufacturing GVA.

  0
                                                                                                 Belgium
       IT    SP     GR     AT     DE     FR     PO     BL      FI    NT     IR      70           France
                                                                                                 Germany
Source: WTO, Morgan Stanley Research                                                             Italy
                                                                                    60           Netherlands
                                                                                                 Greece
… and, finally the pricing power exporters have                                                  Ireland
                                                                                    50           Spain
Exporters’ pricing power tends be to higher for differentiated
products and also depends on the market structure and the                           40

size of the export market. Together with the current capacity
                                                                                    30
utilisation this will determine exporters’ pricing strategy, e.g.
exporters might absorb a stronger EUR in their profit margins                       20
instead of raising their USD selling prices, if they feel that they                         1995            1997            1999               2001      2003         2005           2007          2009       2011



could lose significant market share. The willingness to protect                    Source: Eurostat, Morgan Stanley Research

market share might be further increased at the current juncture                    Exhibit 12
where capacities are underutilised. In this case, the main                         EUR appreciation and its impact on different
impact of a stronger EUR would be to squeeze profits and                           manufacturing sectors
weaken investment rather than dampen export volumes.                                                                                                         Impact of a One Percent EUR Appreciation
                                                                                                                                                       Industrial Production     Producer Prices  Impact on Revenues
                                                                                                                                                                         Size of Response in:
                                                                                                                                                          1Y           2Y          1Y         2Y     1Y        2Y
The extent to which manufacturers can absorb a stronger EUR                        Total industry (excluding construction)                               -0.3         -0.4        -0.2      -0.3    -0.6      -0.7
                                                                                   Manufacturing                                                         -0.4         -0.5        -0.2      -0.2    -0.6      -0.6
in their profit margins is also dictated by the size of their profit                Manufacture of food products and beverages                            0.0          0.0        -0.2      -0.2    -0.2      -0.2
                                                                                    Chemicals and chemical products                                      -0.3         -0.3        -0.3      -0.2    -0.6      -0.5
margins at the outset. As the accompanying chart shows there                        Rubber and plastic products                                          -0.4         -0.5        0.0       -0.1    -0.5      -0.6
                                                                                    Other non-metallic mineral products                                  -0.4         -0.4        0.0       -0.1    -0.4      -0.5
are sizeable differences in profit margins across countries. In                     Basic metals                                                         -0.8         -0.7        -0.5      -0.4    -1.3      -1.2
                                                                                    Fabricated metal products                                            -0.3         -0.4        -0.1      -0.1    -0.4      -0.5
this context, we would highlight France and Italy whose profit                      Machinery and equipment n.e.c.                                       -0.5         -0.8        0.0        0.0    -0.5      -0.8
                                                                                    Office machinery and computers                                       -0.7         -0.8        -0.3      -0.3    -1.0      -1.1
margins seem to be on a multi-year downtrend since 2007 and                         Electrical machinery and apparatus                                   -0.5         -0.6        0.0       -0.1    -0.5      -0.7
                                                                                    Radio, television & communic. equip.                                 -0.7         -0.8        -0.2      -0.2    -0.9      -0.9
whose profit margins did not participate in the margin                              Motor vehicles and trailers                                          -0.5         -0.5        0.0        0.0    -0.5      -0.5
                                                                                    Electricity, gas and water supply                                     0.0          0.0        -0.4      -0.7    -0.4      -0.7
improvements seen in other countries recently. The total
impact on revenues is a function of the combined impact of                         MIG intermediate goods industry
                                                                                   MIG capital goods industry
                                                                                                                                                        -0.5
                                                                                                                                                        -0.5
                                                                                                                                                                   -0.5
                                                                                                                                                                   -0.6
                                                                                                                                                                              -0.2
                                                                                                                                                                              0.0
                                                                                                                                                                                            -0.2
                                                                                                                                                                                             0.0
                                                                                                                                                                                                     -0.8
                                                                                                                                                                                                     -0.5
                                                                                                                                                                                                             -0.7
                                                                                                                                                                                                             -0.7
exchange rate moves on export volumes and domestic prices.                         Consumer goods industry
                                                                                    MIG durable consumer goods industry
                                                                                                                                                        -0.2
                                                                                                                                                        -0.4
                                                                                                                                                                   -0.2
                                                                                                                                                                   -0.3
                                                                                                                                                                              -0.1
                                                                                                                                                                              -0.1
                                                                                                                                                                                            -0.2
                                                                                                                                                                                            -0.1
                                                                                                                                                                                                     -0.3
                                                                                                                                                                                                     -0.4
                                                                                                                                                                                                             -0.4
                                                                                                                                                                                                             -0.5
                                                                                    MIG non-durable consumer goods industry                             -0.1       -0.2       -0.1          -0.2     -0.2    -0.3
                                                                                   MIG energy                                                            0.2        0.2       -0.6          -0.7     -0.4    -0.5

                                                                                   Note: Yellow fields indicate that the estimate is not statistically significant. Simulated impact is
                                                                                   the sum of the impacts for IP and PPI. Source: ECB estimates, Morgan Stanley Research




                                                                                                                                                                                                                       8
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                                                                                                          February 4, 2013
                                                                                                          Strategy and Economics




Foreign affiliate sales are even more important                                                           baseline forecast (see European Economics: Crisis Contained,
Next to the trade channel, foreign affiliate sales of euro area                                           Not Resolved, January 7, 2013). Note that this model-based
companies abroad are another key channel of transmission for                                              simulation only provides a rough guideline. The negative
currency moves. This is because in today’s world of                                                       repercussions could potentially be much more sizeable at the
multi-national companies, foreign affiliate sales (FAS) account                                           current juncture because capacity in the euro area is seriously
for a significant multiple of the direct exports. Depending on                                            underutilised at the moment and because big currency
whether the currency exposure associated with these FAS                                                   movements can also have non-linear effects – in particular in
have been hedged, significant translation effects into reported                                           the periphery where countries were already struggling with
earnings can arise quickly even if the underlying business is                                             their cost competitiveness when the EUR was much weaker
fully hedged by having local production and local sales                                                   and where exports are the only possibly engine of recovery.
perfectly aligned. On this key intra-company trade link, the
USD is far more important than the JPY and GBP, accounting                                                Exhibit 14

for 5 to 7 times as much sales volumes as the direct exports.                                             Stylised impact of a permanent EUR overshoot
                                                                                                                                          Baseline                       EUR Overshoot
                                                                                                                                           2012E     2013E   2014E        2012E    2013E      2014E
Exhibit 13                                                                                                GDP                               -0.5      -0.5     0.9           -0.5      -0.9        0.7
                                                                                                          Consumption                       -0.9      -0.1     0.7           -0.9      -0.1        0.7
Foreign affiliate sales have outgrown direct trade                                                        Investment                        -3.2      -0.8     1.4           -3.2      -1.7        1.7
especially in the US and in the UK                                                                        Domestic Demand                   -1.7      -0.3     0.9           -1.7      -0.6        1.0
                                                                                                          Merchandise exports                2.2       2.7     1.6            2.2       2.0        1.4
8.0                                                                                                       Merchandise imports               -0.6       2.0     1.2           -0.6       2.2        1.4
                     Foreign Affiliates Sales % Exports (2009)                                            Inventory change (GDP Points)     -0.6      -0.6    -0.3           -0.6      -0.7       -0.3
                                                                                                          Value added price                  1.3       1.4     0.9            1.3       1.3        0.5
7.0          United States                                6.8
                                                                                                          Consumer price                     2.5       1.6     1.8            2.5       1.2        1.7
             United Kingdom                                                                               Nominal GDP                        2.0       1.1     2.6            2.0       0.4        2.3
6.0          China (except Hong Kong)                                                                     Wages per Employee                 1.6       1.2     1.2            1.6       0.8        0.7
             Japan                                                                                        Unit Labour Cost                   1.5       1.0     0.4            1.5       1.0       -0.2
                                                                                                          Unemployment rate (% points)      11.2      11.9    12.0           11.2      12.1      12.3
5.0    4.8                                                                                                Employment                        -0.5      -0.6     0.0           -0.5      -0.6       -0.1
                                                                                                          Current account (GDP points)       1.2       1.6     1.7            1.2       1.4        1.5
                                                                                                          Fiscal balance (GDP points)       -3.4      -2.9    -2.8           -3.4      -3.0       -3.0
4.0                               3.7
                                                                3.6         3.5
                                                                                                          Source: INSEE, Morgan Stanley Research estimates
                                        3.1
3.0            2.7                                                    2.6
                            2.4                                                                           Exhibit 15

2.0                                                                               1.8                     Impact of stronger EUR shows a relatively fast
                      1.2                                                               1.2
                                                                                              1.0
                                                                                                          pass-through on GDP in the first four quarters
1.0
                                                                                                    0.4
                                              0.3   0.3                                                                     Impact of a 10% EUR Appreciation on GDP
0.0
                                                                                                            0.0
               Germany                   Spain                  France                    Italy

Source: Eurostat, National Statistics, Morgan Stanley Research                                              -0.1



To sum up: Impact of a stronger EUR                                                                         -0.2


The impact of currency moves on export demand, import
                                                                                                            -0.3
competition and corporate profits also affects the wider euro
area economy. The deterioration in cost competitiveness                                                     -0.4

lowers exports and boosts imports. The subsequent fall in                                                                                                            Impact on Growth
                                                                                                            -0.5
output is partially offset by a fall in inflation (as imports get                                                                                                    Impct on GDP Level


cheaper and unemployment rises further). The stronger                                                       -0.6
                                                                                                                       1          2         3          4             8            12          20
currency causes a terms-of-trade improvement that shelters
consumer spending via lower domestic inflation and higher                                                 Source: INSEE Data, Morgan Stanley Research estimates
affordability of imported goods. At the same time, investment
spending will take a serious hit as will overall economic activity.                                       Joining the dots: Stronger global growth & stronger EUR
Overall, a 10% appreciation in the euro’s external value                                                  The euro area is caught in two different cross-currents at the
reduces GDP by ~ 0.5% in the first year.                                                                  moment: On the one hand there is a recovery in global
                                                                                                          economic activity that might be stronger than expected, but, on
The table below simulates the impact of a permanent increase                                              the other hand, there is a stronger EUR that seems set to
of the trade-weighted exchange rate of the EUR by 10% based                                               appreciate more than previously forecast. To assess the
on a macro econometric model (see Macroeconometric Model                                                  impact of both factors together and the extent to which they
for the Eurozone, October 2011) relative to our current                                                   could possibly offset each other, we used the multipliers used



                                                                                                                                                                                                         9
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                                                                                                           February 4, 2013
                                                                                                           Strategy and Economics




by the ECB and the national central banks in their own                                                     accompanied by unsterilized foreign exchange rate
econometric models. We find that on average, a 10%                                                         intervention (as reportedly being contemplated by the BoJ), is
appreciation of the EUR shaves ~0.7% of EMU GDP while a                                                    not a zero sum game. The resulting overall monetary policy
1% upside surprise in global growth adds 0.1% to EMU GDP                                                   stimulus may have an impact on growth and inflation in
during the first year. On the whole, it would therefore take a                                             countries not engaging in an active weakening of their currency.
very sizeable global growth surprise to offset even a small                                                A ‘currency war’ could therefore create inflation pressures also
appreciation of the EUR in trade-weighted terms.                                                           in countries that have not engaged in the same aggressive
                                                                                                           quantitative easing strategy.
The “map” below identifies the countries that are more
sensitive to global growth (notably Ireland, Spain, Belgium,                                               Over the medium term, this would offset the near-term
the Netherlands and Germany) and those less sensitive to                                                   dampening effect of a stronger EUR on HICP inflation (which is
exchange rate movements (notably Portugal, France and                                                      smaller than the growth impact). Hence, we think that it would
Ireland but also Spain and Belgium). Taking the two                                                        probably take a meaningful and prolonged move above 1.40
parameters together we would expect Ireland, the Benelux                                                   for EURUSD for the ECB to amend its assessment of the
countries and Spain to weather a possible EUR currency war                                                 outlook for price stability in the euro area and thus its monetary
better than some of their peers.                                                                           policy stance.

Exhibit 16                                                                                                 Exhibit 17
Who wins, who loses in a EUR currency war?                                                                 Currency and markets tighten monetary conditions
                                        Impact of Stronger EUR                                              400                             Euroland MCI and components (base: 0 = 01/01/99)                  400
-1.9                                                                                More global demand,
       Relative "Lose-Lose"                                                                                 350                                                                                               350
                                                                                    but more euro
-1.7                                    AUT                                                                                    Refi Rate Effect                                                 MCI
                                                                                    sensitive than the      300                                                                                               300
                                                                                    euro area                                                          Exchange Rate Effect
-1.5                                                                                                        250                                                                                               250

                                                                                                            200
                                                                                                                        3M Euribor Effect                                                                     200
-1.3                                                   GER
                                                                                                            150                                                                                               150
-1.1
                                                    FIN
                                                                                                            100                                                                                               100
-0.9                                                                                                           50                                                                                             50
                                        GRE        EMU                                                          0                                                                                             0
-0.7
                                                                 SPA    Impact of Stronger Global           -50                                                                                               -50
-0.5                                      ITA          NET              Demand                             -100                                                                                               -100
                                                                 BEL
-0.3                                                                                                       -150                                                                                               -150

-0.1
                                          FRA                                                              -200                                                                                               -200
                                                                                            IRE
                                 POR                                                                       -250                                                                                               -250
 0.1
                                                                                                           -300                                                                                               -300
       Less global demand,
 0.3   but less euro sensitive                                                 Relative "Win-Win"          -350                                                                                               -350
       than the euro area
 0.5                                                                                                       -400                                                                                               -400
   -0.06                 -0.01   0.04           0.09             0.14           0.19                0.24        1999            2001          2003        2005       2007      2009      2011         2013

                                                                                                           Source: ECB, Datastream, Morgan Stanley Research
Impact of a 10% EUR appreciation and a 1% increase in global demand on real GDP after 1Yr.
Source: Eurosystem, Morgan Stanley Research                                                                Exhibit 18
                                                                                                           Euro area policy rates vs. EUR/USD cross
Impact on the euro crisis and ECB policy
                                                                                                           9                                                                                            %     1.6
                                                                                                                    %
In our view, a material overshoot could tilt the policy debate on
                                                                                                                                                                                                              1.5
                                                                                                           8
the ECB Governing Council back towards policy rate cuts. On
                                                                                                                                                                                                              1.4
our Monetary Conditions Index (MCI), the recent rally in the                                               7
                                                                                                                                                                                                              1.3
EUR TWI amounts to roughly the same amount of monetary                                                     6
                                                                                                                                                                                                              1.2
tightening as a 100 bp rate hike by the ECB. In a situation,
                                                                                                           5
where money market rates are also on the rise because of                                                                                                                                                      1.1


concerns about LTRO pay-backs and a resulting decline in                                                   4                                                                                                  1


excess liquidity in the system, this could potentially create a                                            3
                                                                                                                                                                                                              0.9

double whammy for economic growth. We would expect the                                                                                                                                                        0.8
                                                                                                           2
ECB to be relatively slow to act though. For starters, some on                                                                                                                                                0.7

the ECB Council members seem to be worried of being forced                                                 1
                                                                                                                                                                                                              0.6
                                                                                                                                Official Policy Rate                    EUR/USD, RHS
into an overly expansionary policy stance through exchange                                                 0                                                                                                  0.5

rate movements. This concern is a valid one, we think,                                                     1970               1976           1982        1988        1994      2000       2006         2012

especially where central bank mandates or social inflation                                                 Before the ECB came into being in 1999, we used the Bundesbank policy rate.
                                                                                                           Source: DataStream, Morgan Stanley Research
preferences differ materially across the Atlantic. Global
monetary policy easing, especially where quantitative easing is



                                                                                                                                                                                                                     10
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                                                                      February 4, 2013
                                                                      Strategy and Economics




Equity Strategy: Investing with a Stronger EUR
Morgan Stanley & Co.    Graham Secker – Equity Strategy               investment implications of currency moves have been different
International plc       Graham.Secker@morganstanley.com
                        Matthew Garman                                in this cycle to the prior period. An example of this can be seen
                        Matthew.Garman@morganstanley.com              in Exhibit 20. In the 15 years preceding 2007 the year-on-year
                                                                      change in EURUSD correlated closely with the year-on-year
                                                                      relative performance (local currency terms) of MSCI Europe ex
•     Over time, a stronger EUR is usually negative for the           UK versus MSCI USA.
      relative performance of European equities (in local
      currency terms).                                                ...however, this rule-of-thumb has weakened since 2007
                                                                      However, since 2007 this correlation has weakened materially
•     We estimate that a 10% rise in trade-weighted EUR would         as European equities have tended to underperform in periods
      hurt European EPS growth by c. 3%.                              of rising EUR (in line with the historic relationship), but then
                                                                      also struggle when EUR was weakening as that depreciation
•     Implications of EUR moves on sector performance can be          reflected sovereign debt concerns. Another way to illustrate
      inconsistent. In general, a stronger EUR tends to favour        this change in relationship is via correlation. Exhibit 21 shows
      Utilities, Retail, Real Estate, Food & Beverages and            that there was a significant negative correlation between the
      Construction & Materials. The relative laggards are often       relative performance of MSCI Europe ex UK and the euro
      Technology, Financials, Autos – we also expect Capital
                                                                      Exhibit 19
      Goods & Healthcare to be at risk of underperforming.
                                                                      Euro denominated investors have not participated in
•     On page 18 we provide a list of stocks that are potentially
                                                                      Japan’s rally
      hurt by a stronger euro. On page 20 we also detail a list of                               130
                                                                                                                                                                              MSCI Japan in YEN
      stocks with relatively high revenue exposure to Japan.                                     125



•
                                                                                                 120
      MSCI UK tends to underperform MSCI EMU in periods of
                                                                        MSCI Japan Price Index




      GBP weakness. Relative sector beneficiaries of a weaker                                    115
                                                                                                                                                                                      MSCI Japan in USD
      GBP are Personal & Household Goods, Healthcare and                                         110

      Chemicals.
                                                                                                 105


                                                                                                 100
EUR denominated investors have not benefitted from
                                                                                                                                                                          MSCI Japan in EUR
Japan rally. Before we discuss the specific investment                                            95

implications of a stronger euro on European equities we want                                      90

to make two, more general, points. First, we traditionally make                                    Jul 12        Aug 12          Sep 12            Oct 12        Nov 12          Dec 12            Jan 13


our investment recommendations on a local currency basis              Source: MSCI, Datastream, Morgan Stanley Research
given that different investors are likely to have different hedging   Exhibit 20
abilities and strategies (subsequent charts show relative             Traditionally a stronger currency implied relative
performance in local currency terms). However, when                   underperformance (and vice versa)…
considering currency moves it makes sense to assess                                              30                                    EURUSD YoY % (positive reading = EUR appreciation)          40

performance in both local and a common currency. While MSCI
                                                                                                                                                                                                         1yr % ch in MSCI US vs MSCI Europe ex UK




                                                                                                                                                                                                   30
Japan has risen by 27% over the last 6M, unhedged USD                                            20


investors would have seen this return reduced to 10% and                                                                                                                                           20
                                                                        1yr % ch in EUR vs USD




                                                                                                 10
unhedged EUR investors to just 1%.                                                                                                                                                                 10
                                                                                                  0
                                                                                                                                                                                                   0
FX appreciation traditionally weighs on regional equity
                                                                                                 -10
performance... The second issue concerns the fact that                                                                                                                                             -10


moves in certain currencies (especially the EUR and YEN) over                                    -20
                                                                                                                                                                                                   -20

the past few years have tended to reflect periods of “risk-on”                                                                                   MSCI US vs MSCI Eur ex UK YoY % - rhs

                                                                                                 -30                                                                                               -30
and “risk-off” rather than, or in addition to, a guide to relative                                 Feb-94   Feb-96   Feb-98   Feb-00    Feb-02     Feb-04   Feb-06   Feb-08     Feb-10    Feb-12

economic fundamentals. This change has meant that the
                                                                      Source: MSCI, Datastream, Morgan Stanley Research




                                                                                                                                                                                                                                                    11
                                                                    MORGAN                                                                 STANLEY                      RESEARCH

                                                                    February 4, 2013
                                                                    Strategy and Economics




 (versus US assets) pre 2009, but a very weak correlation           Exhibit 21

subsequently.                                                       … however, this correlation has weakened
                                                                    materially in recent years
Further 'normalisation' should see traditional relationship                                                               0.2

return. Over the last six months we have even seen European




                                                                      3Y correlation of MSCI Euro ex UK/US vs EURUSD
equities significantly outperform their US peers despite a                                                                0.0
                                                                                                                                 Traditionally, Euro equities underperform US when
stronger euro as investors perceive the latter as symptomatic                                                                    EUR appreciating vs USD...
                                                                                                                          -0.2
of Europe’s falling risk premium. This process may have a bit                                                                                                           … but correlation broken down
                                                                                                                                                                        over last few years
further to run. However, investors should be aware that a
                                                                                                                          -0.4
continued trend toward “normalization” should ultimately see
correlations in Exhibit 21 revert back to more historic norms.                                                            -0.6



With this caveat in mind we now look to analyse the                                                                       -0.8

implications of currency trends, and specifically a EUR
                                                                                                                          -1.0
overshoot, at the market, sector and stock level. We make six                                                               Jan 95    Jan 97       Jan 99      Jan 01   Jan 03    Jan 05        Jan 07     Jan 09     Jan 11

broad points.
                                                                    Source: MSCI, Datastream, Morgan Stanley Research
                                                                    Exhibit 22
1) Stronger currency usually negative for relative                  Strong Euro is traditionally a headwind for European
equity market performance                                           equities’ relative performance
As we mentioned above, over the long run, domestic equity                                                                 110                                                                                                    0.6

performance, relative to other regions, tends to be negatively




                                                                                                                                                                                                                                       MSCI Eur ex UK vs MSCI World (local) - INVERTED
                                                                                                                                                                                              Euro TWI                           0.7
                                                                                                                          105
impacted by a stronger domestic currency. To reiterate the
                                                                                                                                                                                                                                 0.8
point, Exhibit 22 shows a very close relationship between                                                                 100

                                                                                                                                                                                                                                 0.9
moves in the Euro’s trade weighted index and the relative                                                                  95

performance of MSCI Europe ex UK versus MSCI World.
                                                                      Euro TWI




                                                                                                                                                                                                                                 1.0
                                                                                                                           90
Although the relationship has weakened in recent years we still                                                                                                                                                                  1.1

believe that the overall message that a strong currency is                                                                 85
                                                                                                                                                                                                                                 1.2
negative for relative equity performance holds true over the                                                               80
                                                                                                                                                                                                                                 1.3
medium to longer term, and is also particularly important for                                                                                                                              MSCI Europe ex UK vs MSCI
                                                                                                                           75                                                                                                    1.4
investors who believe that markets are ‘normalising’.                                                                                                                                      World - INVERTED - rhs


Consequently, sustained strength in the Euro would likely start                                                            70                                                                                                    1.5
                                                                                                                            Feb 88    Feb 91       Feb 94      Feb 97   Feb 00       Feb 03      Feb 06      Feb 09     Feb 12
to undermine the strong outperformance that the region has
posted over the last six months.                                    Source: MSCI, Datastream, Morgan Stanley Research
                                                                    Exhibit 23

Of course, currency isn’t the only driver of relative performance   Europe’s relative undervaluation gap to the US is
trends. However, when we look at valuation now we find that         nearly closed
European stocks are no longer particularly undervalued                                                                      5
                                                                      Average relative valuations across PB, PD and PCE




compared to global peers. For example:                                                                                      0

                                                                                                                           -5

1) Exhibit 23 shows that the relative valuation between MSCI                                                              -10
                                                                                                                                                                                                   Sector Neutral

Europe and MSCI USA has narrowed from 38% to 29% over                                                                     -15
the last 9 months and is now only around 1% below its 20-year
                                                                                                                          -20
average.
                                                                                                                          -25

                                                                                                                          -30
2) Exhibit 24 shows how that the consensus 12m PE for MSCI
                                                                                                                          -35
EMU relative to MSCI World is now comparable historic
                                                                                                                          -40                                                                              Premium/Discount %
averages.
                                                                                                                          -45
                                                                                                                            Jan 93        Jan 96            Jan 99      Jan 02         Jan 05            Jan 08       Jan 11
3) Exhibit 25 details how the current 12m PE for different
regions compares to the averages recorded over the past 2,3,5       Source: MSCI, Morgan Stanley Research




                                                                                                                                                                                                                                                                                         12
                                                                                                               MORGAN                  STANLEY                 RESEARCH

                                                                                                               February 4, 2013
                                                                                                               Strategy and Economics




and 10 years. Interestingly, Europe/EMU is the most expensive                                                  Exhibit 25

region relative to its average across all time horizons.                                                       EMU equities have seen biggest re-rating relative to
                                                                                                               2, 3 and 5 year averages
Such relative valuations are not necessarily a strong relative                                                                                                        Consensus 12m PE
sell signal given that Europe’s level of profitability and earnings                                                                                                       % away from average:
                                                                                                                                                 Current               2Y        3Y        5Y                   10Y
has lagged global peers in recent years. However, it does                                                      MSCI EMU                             11.4               16        12        12                      0
emphasise that further outperformance of Europe is likely to                                                   MSCI Europe                          11.8               15        12        12                      1
require EPS outperformance and sustained Euro strength                                                         MSCI UK                              11.2               13        11        10                     -1
                                                                                                               MSCI AC World                        12.6               10          8        7                     -3
would be a headwind to such a profit outcome.                                                                  MSCI Japan                           13.6               10          2      -13                    -18
                                                                                                               MSCI USA                             13.5                8          7        5                     -6
                                                                                                               MSCI EM                              10.8                8          3        1                      1
We estimate every 10% rise in the trade-weighted euro
subtracts around 3% from European earnings growth. The                                                         Source: MSCI, IBES, Morgan Stanley Research

most recent quantitative data on the impact of currency                                                        Exhibit 26
movements on earnings is shown in Exhibit 27. Based on work                                                    Revenue exposure of European ex UK companies
from our Global Exposure Guide database, analysts had
                                                                                                                                                       Japan Others
previously estimated that for every 10% fall in the USD against                                                                                  UK     2%    2%
                                                                                                                                                 5%
all European currencies, 2012 EPS would fall by 1.8%.
However, exposure to non-Eurozone regions is around 3.5x                                                                              US
                                                                                                                                     14%
the size of exposure to the US. Eurozone companies generate
14% of their revenues in the US, and around 53% outside of
the Eurozone. This would suggest that a 10% rise in the                                                                                                                                      Europe ex UK
                                                                                                                                                                                                 46%
trade-weighted euro would knock around 7% off Eurozone
EPS (1.8% x 53% / 14%). Given, though, that the Eurozone
accounts for around 45% of pan-European earnings, this would
suggest an overall impact on MSCI Europe’s earnings of
around 3%.                                                                                                             Emerging Markets
                                                                                                                             31%

Exhibit 24
                                                                                                               Note: Emerging markets are defined here as World ex Developed Europe, North America and
Relative EMU equity valuations are in line with                                                                Japan. Data refers to our analysts’ 2012 estimates, based on company information in
historic average                                                                                               combination with their estimates where disclosure is not detailed enough.
                                                                                                               Source: Morgan Stanley Research
                                  120
                                                                                                               Exhibit 27
                                  115
                                                                                                               Our analysts had estimated that a 10% rise in all
                                  110                                                                          European currencies vs USD would reduce earnings
  12m PE MSCI EMU vs MSCI World




                                  105                                                                          by 1.8%
                                  100                                          20Y average
                                                                                                                    Norway
                                  95                                                                                    Italy
                                                                                                                     France
                                  90                                                                               Germany
                                                                                                                Netherlands
                                  85
                                                                                                                    Sweden
                                                                                                                          UK
                                  80
                                                                                                                   Denmark
                                  75         Average since EMU launch 1999                                          Finland
                                                                                                                Switzerland
                                  70                                                                                   Spain
                                   Jan-93   Jan-96      Jan-99        Jan-02   Jan-05        Jan-08   Jan-11       Portugal
                                                                                                                     Greece
                                                                                                                   Belgium
Source: MSCI, Morgan Stanley Research                                                                                Austria
                                                                                                                     Ireland

                                                                                                                     Europe

                                                                                                                                -6         -5         -4        -3         -2        -1         0           1    2
                                                                                                                                           % Impact Of 10% Fall In USD vs All European Currencies On 2012 EPS


                                                                                                               Source: Morgan Stanley Research




                                                                                                                                                                                                                       13
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                                                                    February 4, 2013
                                                                    Strategy and Economics




2) Sector exposure to stronger euro                                 Exhibit 28
                                                                    % of Revenues from developed Europe
While we believe that the impact of currency moves provides
                                                                            Europe
some clear investment implications at the market level, such
                                                                       Real Estate
conclusions are harder to identify at the sector and stock level.         Retailing
                                                                           Utilities
                                                                        Cons Serv
For example, the results from different analysis and                   Telecomms
                                                                             Banks
methodologies can vary considerably, likely reflecting the wide        Food Retail
                                                                         Transport
range of factors that influence the performance of individual            Insurance
                                                                          Software
industries and companies. Below, we summarise the findings             Comm Serv
                                                                             Media
                                                                       Health Care
of three such methodologies.                                                Div Fin
                                                                       Cap Goods
                                                                        Household
                                                                             Autos
#1 – Regional revenue exposure                                               Semis
                                                                          Materials
In Exhibit 28 we rank sectors by the percentage of their               Food & Bev
                                                                           Pharma
                                                                          Cons Dur
revenues that are generated from Europe. While this is              Tech Hardware
                                                                            Energy
somewhat crude, for example it doesn’t account for the
                                                                                       0       10          20         30         40        50       60   70   80        90     100
geographical location of cost bases, it nevertheless provides a
                                                                    Source: Company data, Morgan Stanley Research
simple top-down view on where currency risks may lie.
                                                                    Exhibit 29
On this basis the sectors with the highest degree of overseas       Sector correlations to Euro TWI and USD
exposure, and hence potentially most negatively impacted by a                                          Relative performance of Datastream Europe ex UK indices
                                                                                           Correlation to EUR TWI                              Correlation to EURSUD
stronger euro are Energy, Tech Hardware, Pharmaceuticals,                                    2007-2013     1987-2006                              2007-2013     1987-2006
                                                                    Utilities                       0.69          0.51       Utilities                  0.45          0.50
Consumer Durables (Luxury Goods), Food & Beverages and              Retail                         -0.49          0.37       Real Estate                0.07          0.37
Materials.                                                          Real Estate
                                                                    Food & Bev
                                                                                                   -0.19
                                                                                                   -0.43
                                                                                                                  0.31
                                                                                                                  0.31
                                                                                                                             Con & Mat
                                                                                                                             Retail
                                                                                                                                                        0.33
                                                                                                                                                       -0.65
                                                                                                                                                                      0.33
                                                                                                                                                                      0.32
                                                                    Con & Mat                       0.28          0.30       Food & Bev                -0.68          0.22
                                                                    Financial Svs                  -0.56          0.24       Travel & Leis             -0.42          0.19
The sectors with the least amount of overseas exposure, and         Health Care                    -0.32          0.23       Financial Svs             -0.36          0.17
                                                                    Travel & Leis                  -0.25          0.21       Oil & Gas                  0.28          0.13
perhaps less impacted by a stronger euro, are: Real Estate,         Auto & Parts                    0.04          0.17       Health Care               -0.66          0.12
                                                                    Pers & H/H Gds                 -0.80          0.14       Basic Resource             0.69          0.10
Retailing, Utilities, Consumer Services, Telecoms and Banks.        Oil & Gas                       0.20          0.10       Auto & Parts               0.05          0.08
                                                                    Chemicals                       0.38          0.05       Chemicals                  0.44          0.07
                                                                    Basic Resource                  0.40          0.01       Pers & H/H Gds            -0.66          0.07
                                                                    Inds Gds & Svs                 -0.20          0.00       Inds Gds & Svs             0.13         -0.03
#2 – Correlation to Euro                                            Banks                           0.07         -0.06       Media                     -0.73         -0.07
In Exhibit 29 we show the correlation between the relative          Media
                                                                    Insurance
                                                                                                   -0.63
                                                                                                   -0.02
                                                                                                                 -0.15
                                                                                                                 -0.18
                                                                                                                             Banks
                                                                                                                             Telecom
                                                                                                                                                        0.27
                                                                                                                                                       -0.08
                                                                                                                                                                     -0.10
                                                                                                                                                                     -0.11
performance of European sectors and the Euro since 2007 and         Telecom                         0.32         -0.21       Technology                -0.51         -0.24
                                                                    Technology                     -0.39         -0.33       Insurance                 -0.08         -0.31
between 1987 and 2006. We summarise this data as follows:
                                                                    Source: Datastream, Morgan Stanley Research


i)     Sectors that have a positive correlation to a stronger       Exhibit 30

       currency in both periods are: Utilities; Construction &      Sector performance during periods of Euro strength
       Materials; Oil & Gas, Chemicals; Basic Resources and         / weakness
       Autos.                                                                            Utilities
                                                                                           Media
                                                                                    Health Care
                                                                                           Retail
ii)    Sectors that have a negative correlation in a stronger                Food & Beverages
                                                                                        Telecom
       currency environment in both periods are: Technology;                          Chemicals
                                                                                       Oil & Gas                                                                   Euro Strength
       Insurance and Media.                                                  Financial Services                                                                    Euro Weakness
                                                                                    Technology
                                                                     Industry Goods & Services
                                                                              Equity Investment
iii)   Given our preference for focusing more on the data pre          Construction & Materials
                                                                         Personal & Household
       2007 other sectors to flag up as relative winners of a                       Real Estate
                                                                               Travel & Leisure
       stronger currency are: Retailing; Real Estate; Food &                               Banks
                                                                                      Insurance
       Bev; Financial Services and Travel & Leisure. Additional                    Auto & Parts
                                                                               Basic Resources
       relative losers could be: Telecoms and Banks.                          Market (Absolute)

                                                                                                     -20        -15        -10        -5        0    5   10   15        20     25
                                                                                             Median Ann'd Relative Performance During Periods Of € TWI Strength / Weakness (%)
#3 – Performance in prior periods of Euro strength
In Exhibit 30 we show annualized relative returns of sectors in     Source: Morgan Stanley Research.           Note: Periods of trade weighted Euro strength based
periods of euro strength and weakness. Historically, the            on six prior periods of trade-weighted € strength Sep-89 to May-90, Jul-91 to Aug-92, Feb-94 to
                                                                    Nov-95, Aug-97 to Oct-98, Apr-02 to Jun-03 and Nov-05 to Jul-08.




                                                                                                                                                                                     14
                                                                                        MORGAN           STANLEY               RESEARCH

                                                                                        February 4, 2013
                                                                                        Strategy and Economics




sectors that have performed most strongly during prior periods                          Exhibit 32

of Euro strength have been Utilities, Media, Health Care and                            Country correlations to a stronger Euro
Retailing. Basic resources, Autos, and Insurance are the                                                               Relative performance of Datastream EMU indices
                                                                                                       Correlation to EUR TWI                              Correlation to EURSUD
sectors that have suffered most in prior periods of Euro                                                 2007-2013     1987-2006                             2007-2013      1987-2006
                                                                                        AUSTRIA                 0.08         0.48       BELGIUM                    -0.22          0.37
strength.                                                                               BELGIUM                -0.52         0.36       GREECE                      0.59          0.36
                                                                                        GREECE                  0.76         0.33       AUSTRIA                     0.45          0.36
                                                                                        PORTUGAL                0.54         0.27       PORTUGAL                    0.42          0.33
                                                                                        IRELAND                -0.44         0.20       IRELAND                    -0.17          0.20
The conclusions from exhibits 28-30 highlight the problem with                          GERMANY                -0.14         0.18       SPAIN                       0.32          0.15
                                                                                        FRANCE                 -0.39         0.04       GERMANY                    -0.18          0.07
inconsistency that we flagged earlier. Although the results                             ITALY                   0.16         0.01       ITALY                       0.06          0.00
differ somewhat depending on the methodology we’d highlight                             SPAIN
                                                                                        NETHERLAND
                                                                                                                0.60
                                                                                                               -0.14
                                                                                                                            -0.01
                                                                                                                            -0.15
                                                                                                                                        FRANCE
                                                                                                                                        NETHERLAND
                                                                                                                                                                   -0.66
                                                                                                                                                                    0.21
                                                                                                                                                                                 -0.02
                                                                                                                                                                                 -0.13
the most relevant sector conclusions as follows:                                        FINLAND                 0.18        -0.53       FINLAND                     0.39         -0.37

                                                                                        Source: MSCI, Morgan Stanley Research

i)        Relative winners from a stronger Euro are traditionally:
          Utilities, Retail, Real Estate, Food & Beverages and
          Construction & Materials.

ii)       Relative losers from a stronger Euro are traditionally:
          Technology, Financials, Autos. We’d also flag Healthcare
          and Capital Goods as other sectors potentially at risk of
          EUR-related underperformance at this time.

Our database also allows us to look at the regional exposure of
country stockmarkets as highlighted in Exhibit 31. Further, we
have replicated our correlation analysis for EMU countries in
Exhibit 32. The countries that have generally underperformed
in periods of a stronger euro are Finland and the Netherlands
while Austria, Belgium and Greece have the highest positive
correlations.

Exhibit 31
% of Revenues from developed Europe
          Greece
         Portugal
          Ireland
          Austria
          France
           Spain
             Italy
        Denmark
        Germany
         Sweden
          Norway
  United Kingdom
          Finland
      Netherlands
         Belgium
      Switzerland

                     30   40          50           60            70           80   90
                               % of European revenues from developed Europe


Source: MSCI, Morgan Stanley Research




                                                                                                                                                                                         15
                                                                    MORGAN                                               STANLEY                  RESEARCH

                                                                    February 4, 2013
                                                                    Strategy and Economics




                                                                    over last 25 years) tend to be followed by relative EPS
3) Euro overshoot – not sustained strength
                                                                    underperformance of Euro companies versus their global
The possibility that other regions’ central banks could perhaps     peers. A similar story is observed if we look at the impact of
be more aggressive in fighting currency appreciation than here      Euro strength on the relative price performance of Euro
in Europe could increase investor perceptions of a more             equities too, as illustrated in Exhibit 37.
sustained increase in the Euro. However, our FX strategy team
currently forecast a temporary overshoot in the common              Exhibit 33

currency rather than a sustained period of appreciation. For        On a PPP basis EUR has not yet overshot fair value
example, their Dec-13 forecast for EURUSD remains at 1.26.                                                 25
In this context, investors should be somewhat circumspect                                                  20
about taking longer-term sector positions based on the                                                     15




                                                                      EURUSD % Deviation from Fair Value
analysis above, although the conclusions are likely to be                                                  10
relevant for more tactical investments.                                                                     5

                                                                                                            0
Given that our FX strategists are calling for a temporary Euro                                              -5
overshoot we have also looked at the implications of prior such                                            -10

occurrences. We have approached this in two ways.                                                          -15
                                                                                                                                                          Periods when Euro overshoots fair value
                                                                                                           -20

First, Exhibit 33 comes from our FX strategists and shows a                                                -25

time series of over/under valuation of the Euro based on their                                             -30
                                                                                                             Mar-98   Mar-00   Mar-02         Mar-04      Mar-06      Mar-08      Mar-10          Mar-12
PPP framework. On this chart we have highlighted four periods
where the euro moved above fair value and we have then              Source: Morgan Stanley Research
looked at relative sector performance from that moment up until
the peak in overvaluation. As illustrated in Exhibit 34 this        Exhibit 34
analysis suggests that the best-performing sectors in these         Sector performance in periods where EUR is above
periods were industrial cyclicals and the worst performers          PPP fair value and rising
health care, domestically-focused consumer cyclicals and                                                                                       Relative performance of MSCI Europe ex UK sectors
                                                                                                                                Sep 04 -       Oct 06 -     Feb 09 -  Sep-10 -                                 Hit
consumer staples.                                                                                                                Dec-04         Mar-08       Nov-09     Apr-11    Average    Median          Ratio
                                                                    Chemicals                                                         0.8          31.0          6.7      15.2         13.4      11.0         100
                                                                    Basic Resources                                                 -5.2           34.1         26.7        6.2        15.5      16.5          75
                                                                    Industry Goods & Services                                       -0.5           10.0          3.9        6.8         5.1       5.4          75
One significant note of caution with this analysis, however, is     Construction & Materials
                                                                    Insurance
                                                                                                                                      0.3
                                                                                                                                      3.7
                                                                                                                                                    -1.4
                                                                                                                                                    -7.4
                                                                                                                                                                 8.9
                                                                                                                                                                 6.9
                                                                                                                                                                            7.3
                                                                                                                                                                            3.7
                                                                                                                                                                                        3.8
                                                                                                                                                                                        1.7
                                                                                                                                                                                                  3.8
                                                                                                                                                                                                  3.7
                                                                                                                                                                                                               75
                                                                                                                                                                                                               75
that three of the four periods analysed can be found within the     Financial Services
                                                                    Auto & Parts
                                                                                                                                      1.5
                                                                                                                                    -5.3
                                                                                                                                                    -8.7
                                                                                                                                                   25.6
                                                                                                                                                                 1.2
                                                                                                                                                               -15.5
                                                                                                                                                                            3.1
                                                                                                                                                                          13.7
                                                                                                                                                                                       -0.7
                                                                                                                                                                                        4.6
                                                                                                                                                                                                  1.4
                                                                                                                                                                                                  4.2
                                                                                                                                                                                                               75
                                                                                                                                                                                                               50
                                                                    Utilities                                                         2.9          21.7        -16.6      -4.3          0.9      -0.7          50
last five years and are therefore perhaps less relevant if we       Retail                                                            2.3            6.1        -4.0     -10.6         -1.5      -0.9          50
                                                                    Oil & Gas                                                       -7.4             0.8        -3.3      11.8          0.5      -1.2          50
move back to more traditional relationships. It is noteworthy       Real Estate                                                       1.5         -15.8          0.1      -3.3         -4.4      -1.6          50
                                                                    Telecom                                                           7.4            4.4       -18.8      -9.0         -4.0      -2.3          50
that the relative performance measured in the 2004 period was       Banks                                                             3.8         -18.5         40.1     -11.2          3.5      -3.7          50
                                                                    Personal & Household Goods                                      -1.3            -1.1        11.3      -3.0          1.5      -1.2          25
the opposite of what occurred during the latter three periods.      Food & Beverages                                                 -2.2          19.3         -6.9       -4.1         1.5      -3.1          25
                                                                    Technology                                                      -2.4          -13.6         -6.9        5.2        -4.4      -4.7          25
                                                                    Media                                                             1.0         -15.2        -12.2      -3.3         -7.4      -7.8          25
                                                                    Travel & Leisure                                                  4.6         -12.4        -18.0      -4.4         -7.6      -8.4          25
While Exhibit 33 suggests that the Euro is not yet in overvalued    Health Care                                                     -4.4          -10.2        -14.0      -4.0         -8.2      -7.3            0

territory, the change at the margin (which is often important for   Market                                                              7.6        -6.9        41.5        11.4            13.4        9.5     75


equities) is very significant. For example, in Exhibit 35 we plot   Source: MSCI, Morgan Stanley Research

the percentage change between the current level of the EUR
(trade weighted) and the average reading of the last 12 months.
On this basis we find that the common currency is currently 6%
above its trailing average, a level only surpassed twice in the
last 25 years.

Euro overshoot tends to lead to weaker relative EPS and
price trends
In Exhibit 36 we then plot this same Euro series against the
relative trend of MSCI Europe ex UK EPS versus MSCI World
EPS. This chart suggests that periods where the Euro is 3%
above its trailing 12m average (equivalent to 15% of readings



                                                                                                                                                                                                                     16
                                                                                                                                                                                                       MORGAN                 STANLEY                     RESEARCH

                                                                                                                                                                                                       February 4, 2013
                                                                                                                                                                                                       Strategy and Economics




Exhibit 35                                                                                                                                                                                             Defensives have led the market during Euro overshoots
Current EUR TWI is 6% above its 12m average – only                                                                                                                                                     In Exhibit 38, we have shown the relative sector performance in
seen bigger overshoots in 2003 and 1990                                                                                                                                                                the 6M leading up to the peak in Euro overshoots. Consistent
                                                        10                                                                                                                                             with the weak market performance during Euro overshoots, the
  % ch between current Euro TWI and 12m trailing avg




                                                         8                                                                                                                                             three best sectors have all been defensives - Food & Bev,
                                                         6
                                                                                                                                                                                                       Utilities and Telcos. Cyclicals and Financials have suffered in
                                                         4
                                                                                                                                                                                                       Euro overshoots, with Travel & Leisure, Autos and Banks all
                                                                                                                                                                                                       underperforming by 5/% or more.
                                                         2

                                                         0
                                                                                                                                                                                                       In the 6M post the overshoot, Technology, Media and Travel
                                                         -2
                                                                                                                                                                                                       have been the strongest sectors, while Basic Resources, Real
                                                         -4
                                                                                                                                                                                                       Estate and Retail have been the biggest underperformers.
                                                         -6

                                                         -8                                                                                                                                            Exhibit 38
                                                        -10                                                                                                                                            Sector performance in 6M running up to Euro
                                                          Feb-89   Feb-92      Feb-95          Feb-98     Feb-01     Feb-04      Feb-07      Feb-10
                                                                                                                                                                                                       overshoot
Source: Datastream, Morgan Stanley Research
                                                                                                                                                                                                                   Food & Beverages
Exhibit 36                                                                                                                                                                                                                    Utilities
                                                                                                                                                                                                                             Telecom
Periods of >3% EUR overshoot tend to be followed                                                                                                                                                                                Media
                                                                                                                                                                                                       Equity Investment Instruments
by Euro EPS underperforming global EPS…                                                                                                                                                                                     Oil & Gas
                                                                                                                                                                                                                                Retail
                                                                                                                                                                                                                          Technology
                                                        10                                                                                            180                                                 Industry Goods & Services
                                                                                                                                                                                                                    Basic Resources
   % ch between current Euro TWI and 12m trailing avg




                                                                                                                                                                                                                          Real Estate
                                                         8           EUR/EUR 12m avg                                                                                                                                      Health Care
                                                                                                                                                            MSCI Eur ex UK EPS vs MSCI World EPS




                                                                                                                                                      160                                                   Construction & Materials
                                                         6                                                                                                                                                                 Insurance
                                                                                                                                                                                                        Personal & Household Goods
                                                         4                                                                                                                                                                 Chemicals
                                                                                                                                                      140                                                          Financial Services
                                                                                                                                                                                                                                Banks
                                                         2
                                                                                                                                                                                                                        Auto & Parts
                                                                                                                                                                                                                     Travel & Leisure
                                                         0                                                                                            120
                                                                                                                                                                                                             Europe ex UK (Abs Perf)
                                                         -2
                                                                                                                                                                                                                                          -15            -10            -5            0             5             10
                                                                                                                                                      100
                                                         -4                                                                                                                                                                              Median Relative Sector Performance In 6M Running Up To TW€ Overshoot (%)

                                                         -6
                                                                                                                                                      80                                               Source: Datastream, Morgan Stanley Research
                                                                                                             Europe ex UK EPS rel
                                                         -8                                                  to World EPS - rhs                                                                        Exhibit 39
                                                        -10                                                                                           60                                               Sector performance in 6M after Euro overshoot
                                                          Feb-89   Feb-92    Feb-95       Feb-98        Feb-01     Feb-04     Feb-07      Feb-10

                                                                                                                                                                                                                        Technology
Source: MSCI, Datastream, Morgan Stanley Research                                                                                                                                                                              Media
                                                                                                                                                                                                                   Travel & Leisure
Exhibit 37                                                                                                                                                                                                                  Telecom
                                                                                                                                                                                                                               Banks
… that then tends to prompt relative price                                                                                                                                                                        Equity Investment
                                                                                                                                                                                                                        Health Care
underperformance too                                                                                                                                                                                                         Utilities
                                                                                                                                                                                                       Personal & Household Goods
                                                                                                                                                                                                                 Financial Services
                                                        10          Europe ex UK price                                                                130                                                              Auto & Parts
                                                                                                                                                                                                                          Insurance
   % ch between current Euro TWI and 12m trailing avg




                                                                    index rel to World - rhs
                                                         8                                                                                                                                                       Food & Beverages
                                                                                                                                                            MSCI Eur ex UK index vs MSCI World index




                                                                                                                                                      120                                                Industry Goods & Services
                                                         6                                                                                                                                                                 Oil & Gas
                                                                                                                                                                                                                          Chemicals
                                                                                                                                                      110                                                  Construction & Materials
                                                         4                                                                                                                                                                     Retail
                                                                                                                                                                                                                        Real Estate
                                                         2                                                                                                                                                         Basic Resources
                                                                                                                                                      100
                                                         0                                                                                                                                                  Europe ex UK (Abs Perf)

                                                                                                                                                      90                                                                                 -10             -5            0             5             10             15
                                                         -2
                                                                                                                                                                                                                                                Median Relative Sector Performance In 6M Post TW€ Overshoot (%)
                                                         -4                                                                                           80
                                                                                                                                                                                                       Source: Datastream, Morgan Stanley Research
                                                         -6
                                                                                                                                                      70
                                                                                                                    EUR/EUR 12m avg
                                                         -8

                                                        -10                                                                                           60
                                                          Feb-89   Feb-92    Feb-95       Feb-98        Feb-01     Feb-04     Feb-07      Feb-10


Source: MSCI, Datastream, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                       17
                                                                                                          MORGAN               STANLEY              RESEARCH

                                                                                                          February 4, 2013
                                                                                                          Strategy and Economics




                                                                                                          iii)      Stocks where at least 20% of revenue comes from
4) Stocks exposed to a stronger Euro
                                                                                                                    outside of developed Europe ex UK.
To try and highlight possible implications of a stronger Euro at
the stock level we have constructed a screen based on three                                               In Exhibit 40 we detail the individual names within this screen.
criteria:                                                                                                 Note that, of the 30 stocks that qualified, 9 come from each of
                                                                                                          the Healthcare and Consumer Discretionary sectors. Further,
i)        Stocks where our analysts have estimated that a strong                                          there are 13 French stocks and 8 listed German ones.
          euro would have a negative impact on operating profit                                           Underweight rated stocks include Adidas, Aurubis AG, CRH,
                                                                                                          Essilor, Havas, Luxottica and Merck KGaA.
ii)       Stocks that have a negative correlation to moves in the
          trade weighted euro index over the last 60 months

Exhibit 40
Eurozone Companies Ranked on: 1) Negative / Very Negative Impact from a Stronger Euro; 2) Negative
Correlation to Trade-weighted Euro Over Last 60M and 3) At Least 20% Revenue Exposure from Outside
Developed Europe ex-UK

                                                                                                                                                         Correlation With Trade-         % of 2012e
                                                                                     Market Cap                        MS           Impact From A            Weighted Euro             Revenues From
      Name                            Country         GICS Sector                      ($mn)         Price           Rating         Stronger EUR          52W              60M        Non Dev Eur ex-UK
  1   Luxottica                        Italy          Consumer Discretionary            21,183      € 26.79       Underweight / I   Very Negative         -14.9           -36.6              86.0
  2   Sanofi SA                        France         Health Care                      129,048      € 53.90       Overweight / A    Very Negative         -19.3           -40.0              80.2
  3   EADS                             France         Industrials                       38,380      € 28.76       Overweight / I    Very Negative         -26.8           -49.7              78.5
  4   MTU Aero Engines Holding         Germany        Industrials                        4,971      € 58.99      Equal-Weight / I     Negative            -41.9           -32.2              85.0
  5   Bayer AG                         Germany        Health Care                       80,094      € 51.00       Overweight / A    Very Negative          4.0            -25.8              77.0
  6   DiaSorin S.p.A.                  Italy          Health Care                        2,156      € 22.10             -             Negative              3.5           -34.3              70.0
  7   Essilor International            France         Health Care                       22,339      € 68.76      Underweight / A      Negative            -26.0           -34.0              70.0
  8   Safran                           France         Industrials                       18,949      € 27.11       Overweight / I    Very Negative         -32.4           -31.6              74.0
  9   SES                              Luxembourg     Consumer Discretionary             9,809      € 18.50      Equal-Weight / A     Negative            -23.3           -44.4              69.0
 10   STMicroelectronics NV            France         Information Technology             7,499       € 3.72      Equal-Weight / C   Very Negative         -24.4           -23.6              76.0
 11   HeidelbergCement AG              Germany        Materials                        11,613       € 35.43       Overweight / I    Very Negative          8.3            -13.8              81.5
 12   Adidas                           Germany        Consumer Discretionary           19,463       € 60.42       Underweight / I   Very Negative         -27.4           -15.2              78.0
 13   Fresenius SE                     Germany        Health Care                       21,081      € 76.12      Equal-Weight / I     Negative            -19.2           -54.6              63.0
 14   TOTAL                            France         Energy                           125,729      € 34.59      Equal-Weight / I   Very Negative           9.4           -11.5              85.9
 15   Wolters Kluwer                   Netherlands    Consumer Discretionary            6,125       € 12.35      Equal-Weight / A     Negative             -0.8           -38.3              62.0
 16   LVMH Moet Hennessy Louis Vuitton France         Consumer Discretionary            94,875      € 122.25      Overweight / I      Negative              5.8           -11.4              80.0
 17   Philips                          Netherlands    Industrials                       28,334      € 14.52      Equal-Weight / C     Negative             -6.1           -13.4              75.0
 18   Eni SpA                          Italy          Energy                            94,048      € 15.98       Overweight / I    Very Negative          -3.9            -8.5              85.9
 19   Merck KGaA                       Germany        Health Care                        8,768      € 75.40      Underweight / A    Very Negative          -3.1           -31.4              56.9
 20   BioMerieux SA                    France         Health Care                        3,934      € 64.30             -             Negative             -1.4           -22.5              59.0
 21   Eutelsat Communications          France         Consumer Discretionary             7,482      € 23.31       Overweight / A      Negative            -17.0           -25.0              51.0
 22   Aurubis AG                       Germany        Materials                          3,368      € 39.63       Underweight / I   Very Negative         -15.0            -5.4              83.1
 23   UCB S.A.                         Belgium        Health Care                       10,527      € 39.02       Overweight / A    Very Negative         -16.3            -6.4              63.9
 24   Lagardere                        France         Consumer Discretionary             4,552      € 20.53      Equal-Weight / A     Negative              8.6           -13.4              50.0
 25   Havas                            France         Consumer Discretionary             2,454       € 3.96      Underweight / A      Negative             -8.3            -5.5              66.0
 26   Ipsen                            France         Health Care                        2,964      € 20.60       Overweight / A    Very Negative           9.9           -16.0              23.7
 27   CRH                              Ireland        Materials                         15,409      € 13.45       Underweight / I   Very Negative          7.7             -7.3              55.9
 28   Tod's SPA                        Italy          Consumer Discretionary             4,184      € 83.40      Equal-Weight / I     Negative              2.0            -9.8              27.0
 29   Infineon Technologies AG         Germany        Information Technology             9,638       € 6.43      Equal-Weight / C     Negative              5.4            -5.9              50.0
 30   Rexel S.A.                       France         Industrials                        5,964      € 14.93       Overweight / C      Negative              7.2            -2.4              55.0
Source: MSCI, Haver Analytics, Morgan Stanley Research
Note: A negative (very negative) impact from a stronger euro implies a low single-digit (greater than low single digit) impact on company's EBIT (or most applicable form of operating profit) from a rise
in the euro. Correlation calculated on monthly (weekly) relative performance of stock vs. moves in the trade-weighted euro over a 60M (52W) period. Negative correlation implies as euro goes up
(down) the company underperforms (outperforms).
For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure Website at
www.morganstanley.com/researchdisclosures.
For important disclosures regarding non-covered companies (DiaSorin, BioMerieux) that are the subject of this screen, please refer to the Disclosure Section, located at the end of this report.




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                                                                     February 4, 2013
                                                                     Strategy and Economics




5) Implications of the EURYEN move                                   Exhibit 41
                                                                     MSCI Europe tends to underperform MSCI Japan
Given that the Euro’s appreciation has been most significant         when the Euro appreciates against the Yen
against the Yen we have also looked at some specific
implications on this axis. We note the following.                                180                                                                                   95

                                                                                 170                                                        EUR/YEN                    90




                                                                                                                                                                             MSCI Japan vs Msci Europe ex UK (local)
First, historically MSCI Europe has underperformed MSCI                          160
                                                                                                                                                                       85
Japan when the Euro is appreciating against the Yen. As                          150
                                                                                                                                                                       80
illustrated in Exhibit 41, this relationship can last for a number               140




                                                                       EUR/YEN
                                                                                                                                                                       75
of years. For example, Japanese stocks outperformed                              130
European ones from 2002 to 2006 while the Euro was                               120
                                                                                                                                                                       70

appreciating against the Yen, and then underperformed for                                                                                                              65
                                                                                 110
much of the last five years as the currencies reversed path.                                                                                                           60
                                                                                 100

                                                                                 90                                      MSCI Japan vs MSCI Eur x UK - rhs             55
In Exhibit 42 we show that European companies generate just
                                                                                 80                                                                                     50
2% of their revenues from Japan, however, as traditional                          Dec-98    Dec-00     Dec-02    Dec-04       Dec-06       Dec-08       Dec-10     Dec-12

exporter economies it is likely that the currency has wider
                                                                     Source: MSCI, Datastream, Morgan Stanley Research
implications than just direct revenue exposure. The point that a
stronger euro is likely to lead to MSCI Europe underperforming       Exhibit 42
MSCI Japan is supported by our relative EPS assumptions too.         Revenue exposure of European companies
Arguably, Japanese EPS is likely to be boosted by both a
                                                                                                          Japan Others
weaker currency and more aggressive fiscal policy, whereas in                                              2%    2%

                                                                                                  US
Europe the combination of continued austerity (albeit at a                                       14%

declining rate) and a stronger currency provides an EPS
headwind. Note that we forecast European EPS to grow 5%
this year (3% excluding financials) whereas our Japanese
strategist Yohei Yamada forecasts Japanese EPS to rise 56%.
                                                                                                                                                    Developed Europe
                                                                                                                                                          51%
Using data from our Global Exposure Guide Exhibit 43 details a
list of European companies whose revenue exposure to Japan
is relatively high in the context of the wider market.                                     EM
                                                                                           31%




                                                                     Note: Emerging markets are defined here as World ex Developed Europe, North America and
                                                                     Japan. Data refers to our analysts’ 2012 estimates, based on company information in
                                                                     combination with their estimates where disclosure is not detailed enough.
                                                                     Source: Morgan Stanley Research




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Exhibit 43
Top 20 European companies with the highest revenue exposure to Japan
                                                                                                                                                         Market Cap       % of 2012e revenues
Company Name                           Sector                        Industry Group                                   Country            Price           $mn                      Japan
Burberry                               Consumer Discretionary        Consumer Durables & Apparel                      United Kingdom     £13.87          9,654                     25.5
APR Energy                             Utilities                     Utilities                                        United Kingdom     £7.13           878                       25.0
Dassault Systemes SA                   Information Technology        Software & Services                              France             €82.84          14,131                    18.0
Nobel Biocare                          Health Care                   Health Care Equipment & Services                 Switzerland        CHF9.46         1,297                     15.0
Wolfson Microelectronics               Information Technology        Semiconductors & Semiconductor Equipment         United Kingdom     £2.0225         371                       14.0
Eramet SA                              Materials                     Materials                                        France             €105.65         3,841                     12.8
STMicroelectronics NV                  Information Technology        Semiconductors & Semiconductor Equipment         France             €6.642          8,283                     12.0
Renewable Energy Corporation           Information Technology        Semiconductors & Semiconductor Equipment         Norway             NOK1.1          428                       12.0
ICAP                                   Financials                    Diversified Financials                           United Kingdom     £3.292          3,349                     11.3
ARM Holdings Plc                       Information Technology        Semiconductors & Semiconductor Equipment         United Kingdom     £8.935          19,424                    11.0
Tullett Prebon                         Financials                    Diversified Financials                           United Kingdom     £2.425          831                       11.0
African Barrick Gold Plc               Materials                     Materials                                        United Kingdom     £3.66           2,363                     11.0
Air Liquide                            Materials                     Materials                                        France             €95.96          41,042                    10.5
Novo Nordisk                           Health Care                   Pharmaceuticals, Biotechnology & Life Sciences   Denmark            DKK1041         86,475                    10.2
Elekta AB                              Health Care                   Health Care Equipment & Services                 Sweden             SEK96.6         5,667                     10.0
Sanofi SA                              Health Care                   Pharmaceuticals, Biotechnology & Life Sciences   France             €72.1           130,974                    9.3
LVMH Moet Hennessy Louis Vuitton SA    Consumer Discretionary        Consumer Durables & Apparel                      France             €139.85         97,333                     9.0
AstraZeneca                            Health Care                   Pharmaceuticals, Biotechnology & Life Sciences   United Kingdom     £30.685         60,295                     8.7
Richemont SA                           Consumer Discretionary        Consumer Durables & Apparel                      Switzerland        CHF77.1         44,574                     8.1
BHP Billiton Plc                       Materials                     Materials                                        United Kingdom     £22.145         73,640                     8.0

Source: Company Data, Morgan Stanley Research
Note: Data refers to our analysts' 2012 estimates, based on company information in combination with our analysts' estimates where disclosure is not detailed enough.
For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure Website at
www.morganstanley.com/researchdisclosures. For important disclosures regarding non-covered companies (DiaSorin, BioMerieux) that are the subject of this screen, please refer to the Disclosure
Section, located at the end of this report.




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                                                                                          February 4, 2013
                                                                                          Strategy and Economics




6) Implications of the GBP / EUR move                                                     Exhibit 45
                                                                                          MSCI UK tends to outperform MSCI EMU during
Given the recent appreciation of the EUR vs GBP, we have                                  periods of sterling weakness…
looked at the potential implications of a weaker sterling.
                                                                                                                 50


Historically, UK equity markets have been relatively consistent                                                  40

beneficiaries from GBP weakness. As we show in Exhibit 46,                                                       30
sterling’s strength through much of the late 90s and early




                                                                                            12M Change (%)
                                                                                                                 20
2000s led to the UK having it’s weakest periods of relative
performance vs the rest of Europe, while the UK outperformed                                                     10

strongly through GBP weakness during 2007-9. However, as                                                         0
illustrated in Exhibit 45, the correlation between the UK’s
                                                                                                             -10
relative performance and currency moves has actually
reversed in the last few years, with EMU’s outperformance                                                    -20                          GBP / EUR
                                                                                                                                          MSCI EMU vs MSCI UK
coinciding with periods of Euro strength.                                                                    -30
                                                                                                                      95        96        97    98    99    00    01    02    03    04    05    06   07   08   09   10   11   12   13

In Exhibit 47, we have shown the correlation between relative
                                                                                          Source: MSCI, Datastream, Morgan Stanley Research
sector performance and moves in GBP vs both EUR and USD.
                                                                                          Exhibit 46
The sectors that have traditionally shown the most consistent
benefit from GBP weakness have been personal & household                                  … but the correlation to FX moves has actually
goods, health care and chemicals. Those that have generally                               reversed in recent years
suffered from a weaker GBP have been oil & gas, real estate                                         60            3Y Correlation Between 52W Change In GBP / EUR and 52W Change In MSCI UK vs MSCI EMU (%)

and financial services.                                                                             40


                                                                                                    20
At the stock level, we have shown in Exhibit 48 a list of UK
companies where our analysts have highlighted a weaker GBP                                                   0

as having a positive impact on operating profit and where the
                                                                                               -20
stock has exhibited a negative correlation with sterling.
                                                                                               -40

Exhibit 44
                                                                                               -60
Revenue exposure of UK companies
                                                                                               -80
                            Japan Others
                             2%    3%
                                                                                           -100
                                                                                                                 95        96        97        98    99    00    01    02    03    04    05    06    07   08   09   10   11   12   13
                  US
                 15%                                     UK
                                                         30%                              Source: MSCI, Datastream, Morgan Stanley Research

                                                                                          Exhibit 47
                                                                                          Sector correlations to GBP/EUR and GBP/USD
                                                                                                                                                           Relative performance of Datastream UK indices
                                                                                                                                          Correlation to GBP / EUR                             Correlation to GBP / USD
                                                                                                                                            2007-2013     1987-2006                              2007-2013     1987-2006
                                                                                          Financial Svs                                            0.51         0.32        Utilities                  -0.40          0.19
                                                                                          Technology                                               0.08         0.30        Retail                     -0.24          0.17
                                                                                          Real Estate                                              0.64         0.30        Real Estate                 0.55          0.16
                                                                                          Insurance                                                0.49         0.14        Food & Bev                 -0.69          0.15
                                                        Developed Europe                  Telecom                                                  0.04         0.08        Travel & Leis               0.16          0.11
                EM                                            ex UK                       Banks                                                    0.61         0.04        Oil & Gas                  -0.60          0.07
                33%                                            17%                        Oil & Gas                                               -0.77         0.03        Con & Mat                   0.32          0.03
                                                                                          Media                                                    0.50        -0.02        Financial Svs               0.62          0.01
                                                                                          Basic Resource                                          -0.08        -0.05        Telecom                     0.12          0.01
                                                                                          Inds Gds & Svs                                           0.70        -0.07        Basic Resource              0.57          0.00
Note: Emerging markets are defined here as World ex Developed Europe, North America and   Travel & Leis                                            0.67        -0.08        Auto & Parts                0.65         -0.01
Japan. Data refers to our analysts’ 2012 estimates, based on company information in       Chemicals                                                0.36        -0.09        Chemicals                   0.68         -0.03
combination with their estimates where disclosure is not detailed enough.                 Auto & Parts                                             0.61        -0.10        Pers & H/H Gds             -0.55         -0.03
Source: Morgan Stanley Research                                                           Utilities                                               -0.20        -0.13        Health Care                -0.87         -0.03
                                                                                          Food & Bev                                              -0.18        -0.15        Technology                 -0.32         -0.07
                                                                                          Con & Mat                                                0.10        -0.17        Insurance                   0.32         -0.14
                                                                                          Health Care                                             -0.44        -0.18        Media                      -0.13         -0.17
                                                                                          Retail                                                  -0.08        -0.26        Inds Gds & Svs              0.09         -0.28
                                                                                          Pers & H/H Gds                                          -0.21        -0.37        Banks                       0.54         -0.37

                                                                                          Source: Datastream, Morgan Stanley Research




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                                                                                                         February 4, 2013
                                                                                                         Strategy and Economics




Exhibit 48
UK stocks ranked on: 1) Positive / very positive impact from a weaker GBP and 2) Negative correlation to
trade-weighted GBP over last 60M
                                                                                                                                           Correlation With Trade-
                                                                  Market                               MS              Impact From A           Weighted GBP                 % Of 2012e Revenues
Co. name                     GICS Sector                        Cap ($mn)         Price              Rating             Weaker GBP            52W            60M            From Outside The UK
UBM plc                      Consumer Discretionary               2,968           £ 7.65         Overweight / A           Positive              0.0         -34.0                    87.0
Pearson                      Consumer Discretionary              15,303          £ 11.85        Underweight / A           Positive              9.8         -32.6                    86.0
Shire PLC                    Health Care                         18,608          £ 21.10         Overweight / A         Very Positive          -8.5         -32.4                    96.0
Informa                      Consumer Discretionary               4,574           £ 4.80         Overweight / A           Positive            -18.0         -31.7                    85.0
GlaxoSmithKline              Health Care                         109,689         £ 14.16        Equal-Weight / A        Very Positive          -7.1         -23.5                    94.9
AstraZeneca                  Health Care                          62,204         £ 31.57        Equal-Weight / A        Very Positive         -25.3         -21.0                    94.0
WPP Group Plc                Consumer Discretionary              19,595           £ 9.80        Equal-Weight / A          Positive             22.7         -15.2                    87.0
Reed Elsevier PLC            Consumer Discretionary              13,072          £ 6.92          Overweight / A           Positive            -19.7         -12.6                    93.0
Smiths Group                 Industrials                          7,730          £ 12.44        Equal-Weight / C          Positive             -6.6          -3.9                    96.0

Source: MSCI, Haver Analytics, Morgan Stanley Research
Note: A positive (very positive) impact from a weaker GBP implies a low single-digit (greater than low single-digit) positive impact on company's EBIT (or most applicable form of operating profit) from
a fall in the GBP. Correlation calculated on monthly (weekly) relative performance of stock vs. moves in the trade-weighted GBP over a 60M (52W) period. Negative correlation implies as GBP goes
down (up) the company outperforms (underperforms). For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure
Website at www.morganstanley.com/researchdisclosures.




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                                                                               Strategy and Economics




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                                                                                                                                                           23
                                                                                              MORGAN            STANLEY           RESEARCH

                                                                                              February 4, 2013
                                                                                              Strategy and Economics




weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy
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                              Coverage Universe    Investment Banking Clients (IBC)
                                             % of                   % of % of Rating
    Stock Rating Category        Count       Total     Count Total IBC Category
Overweight/Buy                    1040          36%           400          39%           38%
Equal-weight/Hold                 1278          44%           483          47%           38%
Not-Rated/Hold                     106           4%            27           3%           25%
Underweight/Sell                   479          17%           108          11%           23%
Total                            2,903                       1018
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                                                                                             February 4, 2013
                                                                                             Strategy and Economics




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                                                          MORGAN    STANLEY            RESEARCH




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