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Morgan Stanley -Autumn Update – More

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					                                                             MORGAN                STANLEY                 RESEARCH
                                                             EUROPE


                                                             Morgan Stanley & Co. International       Graham Secker
                                                             plc+
                                                                                                      Graham.Secker@morganstanley.com
                                                                                                      +44 (0)20 7425 6188

                                                                                                      Ronan Carr, CFA
                                                                                                      Matthew Garman, CFA
                                                                                                      Krupa Patel
September 4, 2013                                                                                     Hanyi Lim


European Strategy
Autumn Update – More
upside, after a pause
Tactical caution, but stocks higher in medium-term
We remain tactically cautious on European equities and
see further downside in the short-term. However,
ultimately the macro backdrop remains supportive for
equities longer-term.

Raising rolling 12m price target to 1350
We raise our rolling 12m price target for MSCI Europe to
1350, offering 7% upside from here. This increase is
driven by rolling forward our EPS projections into 2015
rather than any inherent upgrade to either our EPS
forecasts or PE assumptions. We raise our FTSE100
target to 7170.

Base case EPS growth profile is 1%, 9% and 10%
We now forecast European EPS growth of 1% in 2013
(down from +5%), +9% in 2014 (unchanged) and
introduce a new 2015 estimate of +10%.

Leaving our 12m PE assumption unchanged at 12.5
We leave our base case fair value 12m PE assumption
unchanged at 12.5. This reflects the positive influence of
improving EPS trends and equity inflows versus the           The information contained herein has been prepared
potential negative impact from QE tapering.                  solely for informational purposes and is not a solicitation
                                                             of any offer to buy or sell any security or other financial
OW Financials remains our key recommendation                 instrument or to participate in any trading strategy.
                                                             Products and trades of this type may not be appropriate
Our key investment themes include: 1) OW Value (with
                                                             for every investor. Please consult with your legal and tax
growth); 2) OW Financials; 3) Buying European                advisors before making any investment decision.
exposure; 4) Stocks offering dividend growth and yield;      Please contact your Morgan Stanley sales representative
5) Caution on cyclicals given high relative valuations.      for more details.

Downgrading Consumer Discretionary and Div Fins,
                                                             Morgan Stanley does and seeks to do business with
Upgrading Insurance and Telecoms                             companies covered in Morgan Stanley Research. As
We downgrade Consumer Discretionary to Neutral on            a result, investors should be aware that the firm may
valuation grounds and raise our defensive exposure by        have a conflict of interest that could affect the
upping Telecoms to neutral. We also upgrade Insurance        objectivity of Morgan Stanley Research. Investors
to OW and downgrade Diversified Financials to Neutral.       should consider Morgan Stanley Research as only a
                                                             single factor in making their investment decision.
                                                             For analyst certification and other important
                                                             disclosures, refer to the Disclosure Section,
                                                             located at the end of this report.
                                                             += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be
                                                             associated persons of the member and may not be subject to NASD/NYSE restrictions on
                                                             communications with a subject company, public appearances and trading securities held by a
                                                             research analyst account.
                                                                  MORGAN           STANLEY            RESEARCH

                                                                  September 4, 2013
                                                                  European Strategy




Autumn Update – More upside, after a pause
                                                                  Revisiting MS’s big picture macro assumptions
Summary                                                           As part of a regular global exercise, our economists and
                                                                  cross-asset strategists have revisited their main forecasts and
In recent weeks we have argued that the tactical outlook for      assumptions. In this report, we review our own forecasts that
European equities is deteriorating due to a combination of
                                                                  we laid out in our Spring Update publication Spring Update -
factors including a rollover in economic surprise indices,
higher bond yields, elevated sentiment and risk appetite, our     More Upside on a 12m View, 17 March 2013. This report
MTI above 0SD and a number of risk events such as QE              follows on from our economists’ update Back-to-School Global
tapering and the German constitutional court ruling on the        Macro Outlook, 02 September 2013 and complements a
OMT. However, while we believe markets remain vulnerable          cross-asset strategy report Global Strategy Outlook: Dealing
to a pullback in the short-term, we remain constructive on        With Daylight, 3 September, 2013’, which provides a brief
European stocks from a medium-term perspective.                   summary of our views across major global asset classes.

In this report we raise our rolling 12m price target for MSCI
Europe to 1350, offering 7% upside. The increase in this          We debate the outlook for EPS growth and the PE ratio
price target is driven by rolling forward our EPS projections     In our Spring Update report, we identified three key debates
into 2015 rather than any inherent upgrade to either our EPS      that we thought would be the main determinants of European
forecasts or PE assumptions. We raise our FTSE100 target          equity markets this year. These were: 1) Can policy gain
to 7170.                                                          traction and generate stronger economic growth? 2) Will
                                                                  European margins expand in 2013? 3) Can the PE rise further?
Post recent revisions to our economists’ global GDP               Given that the answer to the first question now appears to be
forecasts we have revisited our EPS assumptions in this
                                                                  yes, we focus here on the latter two issues. Specifically: i) How
report. We now forecast European EPS growth of 1% in
2013 (down from +5%), +9% in 2014 (unchanged) and                 much of an EPS recovery can we expect over the next year?
introduce a new 2015 estimate of +10%.                            and ii) What we think is likely to happen to Europe’s PE ratio?

Post a near record rebound in Europe’s 12m PE over the last       #1 How much of an EPS recovery will MSCI Europe
two years we believe the market is unlikely to re-rate            see over the next year?
materially further at this time and leave our base case ‘fair
value’ estimate unchanged at 12.5. While EPS trends and           Modest changes to our economists’ GDP forecasts…
equity inflows may put some upward pressure on PE ratios          In their own Autumn Update, our economists made some
going forward, we believe QE tapering will likely exert some      modest amendments to their GDP forecasts, with their new
downward pressure on valuations. Historically, equity             estimates illustrated in Exhibit 1. Overall, they now see global
valuations usually peak when inflation troughs and then start
                                                                  GDP growth of 2.9% in 2013 (previously 3.1%) and 3.5% in
to de-rate as we get close to the start of monetary tightening.
                                                                  2014 (previously 3.9%). The largest regional changes were for
Since early May we have been recommending investors OW            2014, where they upgraded their UK GDP growth forecast from
stocks offering a combination of Value, cyclicality and           1.4% to 2.4% and downgraded EM GDP growth from 5.7% to
exposure to Europe. Although this theme has become more           4.9%.
consensual we still believe it has further to run post years of
underperformance, undemanding valuations and good                 Exhibit 1
relative earnings revisions. Financials remain our preferred      Our new economic forecasts
way to gain exposure to this theme given lower valuations
                                                                                     2012               2013E                 2014E
than cyclicals.                                                   %Y                           Bear     Base    Bull   Bear   Base    Bull
                                                                  GLOBAL              3.2       2.6      2.9    3.2     2.4    3.5    4.1
                                                                   G10                1.5       0.8      1.0    1.2     1.1    2.0    2.6
In our European Model Portfolio we downgrade Consumer                 US              2.8       1.6      1.6    1.7     1.9    2.7    3.3
                                                                      Euro Area      -0.5      -0.7      -0.5   -0.3   -0.1    0.9    1.6
Discretionary, and upgrade Telecoms, to Neutral. In general,          Japan           2.0       1.1      1.6    1.8     0.3    1.3    1.8
we believe the relative valuations of cyclicals are elevated          UK              0.2       1.3      1.4    1.5     1.2    2.4    3.4
                                                                   EM                 4.9       4.2      4.8    5.1     3.6    4.9    5.6
versus history – this is particularly true for Consumer               China          7.8        7.0      7.6    7.7     5.8    7.1    7.3
Discretionary which is close to a record high on normalized           India           5.1       4.1      4.4    4.6     3.3    4.6    5.5
                                                                      Brazil          0.9       1.5      2.1    2.4     1.0    1.7    2.8
PE. We also upgrade Insurance to OW and downgrade                     Russia          3.4       1.5      2.2    2.9     1.5    3.1    3.8
Diversified Financials to Neutral.                                Source: Morgan Stanley Research estimates




                                                                                                                                             2
                                                                    MORGAN                                                STANLEY                           RESEARCH

                                                                    September 4, 2013
                                                                    European Strategy




… and hence little impact on our EPS forecasts                      Exhibit 2

In Exhibit 2 we incorporate these new GDP forecasts into our        MS GDP forecasts weighted by geographical
top-down earnings model. As illustrated, the model suggests         revenue exposure
European companies will see revenue-weighted global GDP                               European
                                                                                     Company's                                                                                               Contribution To Revenue-Weighted
growth in 2013 of 1.6% (real) and 4.6% (nominal), rising to                           Revenue
                                                                                       Split %       2012
                                                                                                           Real GDP Growth (%)
                                                                                                              2013     2014    2015                                                          2012
                                                                                                                                                                                                 Global Real GDP Growth (%)
                                                                                                                                                                                                        2013    2014     2015
2.6% and 5.5% in 2014 and 2.7% and 5.6% in 2015,                    UK
                                                                    Europe x UK
                                                                                         10.1
                                                                                         36.3
                                                                                                      0.2
                                                                                                      -0.5
                                                                                                               1.4
                                                                                                              -0.5
                                                                                                                        2.4
                                                                                                                        0.9
                                                                                                                                2.1
                                                                                                                                1.2
                                                                                                                                                                                              0.0
                                                                                                                                                                                              -0.2
                                                                                                                                                                                                         0.1
                                                                                                                                                                                                        -0.2
                                                                                                                                                                                                                 0.2
                                                                                                                                                                                                                 0.3
                                                                                                                                                                                                                          0.2
                                                                                                                                                                                                                          0.4
                                                                    US                   17.5         2.8      1.6      2.7     2.6                                                           0.5        0.3     0.5      0.5
respectively. Historically, European EPS growth has tended to       Asia ex Japan        12.7         6.2      6.0      5.9     6.1                                                           0.8        0.8     0.8      0.9
                                                                    Australia             1.0         3.6      2.6      2.6     2.7                                                           0.0        0.0     0.0      0.0
correlate most closely to our real revenue-weighted global          Japan                 2.3         2.0      1.6      1.3     1.3                                                           0.0        0.0     0.0      0.0
                                                                    LatAm                 9.2         2.8      2.8      3.0     3.0                                                           0.3        0.3     0.3      0.3
GDP growth series, and Exhibit 3 shows what these new               CEEMEA               10.9         2.7      2.5      3.6     3.7                                                           0.3        0.3     0.4      0.4
                                                                    Revenue-Weighted Global GDP Growth
forecasts imply for EPS growth – namely flattish EPS growth         Real
                                                                    Nominal
                                                                                                      1.7
                                                                                                      5.1
                                                                                                               1.6
                                                                                                               4.6
                                                                                                                        2.6
                                                                                                                        5.5
                                                                                                                                2.7
                                                                                                                                5.6
                                                                                                                                                                                              1.7
                                                                                                                                                                                              5.1
                                                                                                                                                                                                         1.6
                                                                                                                                                                                                         4.6
                                                                                                                                                                                                                    2.6
                                                                                                                                                                                                                    5.5
                                                                                                                                                                                                                               2.7
                                                                                                                                                                                                                               5.6
this year followed by high single-digit EPS growth in 2014 and
                                                                    Source: Morgan Stanley Research Estimates
2015.
                                                                    Exhibit 3
EGLI suggests 7% EPS growth over N12M                               MS GDP forecasts point to high single-digit EPS
Our other model for forecasting EPS growth is our Earnings          growth in 2014 and 2015
Growth Lead Indicator (EGLI), as illustrated in Exhibit 4. This
                                                                                                  60
indicator suggests European EPS will grow by 7% over the
next 12 months, a figure that is consistent with the results from                                 40                                                                                                y = 8.5728x - 15.029
                                                                                                                                                                                                          2
our GDP-driven top-down methodology above.                                                                                                                                                               R = 0.4271
                                                                     MSCI Europe EPS Growth (%)




                                                                                                  20

Margins look set to expand in 2014
When constructing our top-down EPS forecasts the other input                                       0

                                                                                                                                                                                                  Revenue-weighted global
to consider is the likely direction of corporate margins.                                                                                                                                         GDP growth forecasts:
                                                                                                  -20                                                                                             2013e = +1.6%
Although Exhibit 5 shows that European margins have been                                                                                                                                          2014e = +2.6%
                                                                                                                                                                                                  2015e = +2.7%
falling since early 2011, our proprietary Margin Lead Indicator                                   -40
                                                                                                                                                                                                  Implied EPS growth:
model shown in Exhibit 6 suggests that profitability can actually                                                                                                                                 2013e = -1.0%
                                                                                                                                                                                                  2014e = +7.0%
expand in 2014. In our prior forecasts we assumed 15bps of                                        -60                                                                                             2015e = +8.1%
                                                                                                        -4          -3         -2         -1           0             1         2         3          4          5          6          7
margin contraction in 2013 and 25bps of expansion in 2014.                                                                                     Revenue-Weighted Real GDP Growth (%)

We continue to expect the same figure in 2014 after modest
                                                                    Source: World Bank, MSCI, Morgan Stanley Research Estimates
margin expansion this year.                                         Note: Revenue weighted GDP growth based on 9 historical editions of the Global Exposure
                                                                    Guide back to 1997. Pre-1997 we assume the revenue weights developed in-line with
                                                                    globalisation trends seen in US over the same period.
1H weakness means we cut our top-down 2013 EPS
growth forecast from 5% to 1%
In response to more disappointing EPS performance in the first
half of this year, we are cutting our 2013 EPS growth forecast      Exhibit 4

from 5% (3% ex financials) to 1% (-3% ex financials). This new      Our EGLI points to 7% EPS growth over N12M
forecast of 1% is consistent with the message from our                    60

top-down earnings model. Given that we estimate European
EPS is down around 5% through the 1H13, our new forecast                  40

does imply some EPS growth in 2H13.
                                                                          20


We forecast 9% EPS growth in 2014 and 10% in 2015
                                                                                          0
For 2014 we leave our existing forecast of 9% EPS growth
unchanged. This reflects the fact that there has been minimal       -20
change to our 2014 real or nominal revenue-weighted GDP
growth forecasts and our previous assumption of 25bps of            -40

margin expansion next year is consistent with the current                                                     MSCI Europe EPS Growth (YoY %)
                                                                                                              EGLI Model (Based On OECD, IFO, GSCI)
message from our Margin Lead Indicator. We introduce a new          -60
                                                                                                  70     72    74    76   78    80   82    84     86       88   90       92   94   96   98   00   02    04   06    08   10    12   14
2015 EPS growth forecast of 10%.
                                                                    Source: MSCI, OECD, IFO, GSCI, Morgan Stanley Research




                                                                                                                                                                                                                                         3
                                                                                                    MORGAN                STANLEY                   RESEARCH

                                                                                                    September 4, 2013
                                                                                                    European Strategy




Exhibit 5                                                                                           Exhibit 6
European margins showing signs of stabilizing after                                                 Our margin lead indicator points to 25bps of
2.5 years of contraction                                                                            expansion in 2014
15        MSCI Europe EBIT Margins (%)                                                                200

             Trailing 12M                                                                             150
             Next 12M
             Next 24M
14                                                                                                    100


                                                                                                       50


13                                                                                                      0


                                                                                                       -50


12                                                                                                    -100


                                                                                                      -150
                                                                                                                                MSCI Europe ex Financials YoY Change In 12M Trailing EBITDA Margin (bp)
11                                                                                                    -200                      Margin Lead Indicator
     06           07          08         09    10         11         12         13                           01   02     03     04     05     06     07     08     09     10    11     12     13     14


Source: MSCI, IBES, Morgan Stanley Research                                                         Source: MSCI, IBES, Datastream, CRB, Philly Fed, CEPR, Eurostat, Morgan Stanley
                                                                                                    Research
                                                                                                    Note: The Margin Lead Indicator is based on a regression analysis of the oil price, oil price
                                                                                                    relative to CRB spot index, CPI – PPI inflation, Philly Fed output vs. input prices, Eurocoin
                                                                                                    index (a monthly estimate of EA GDP growth) and consensus expectations of margin
                                                                                                    expansion.


Exhibit 7
MSCI Europe ex Financials P&L
                                                                 Income Statement ($bn)                                                                     YoY Growth (%)

                                                     2012e                 2013e             2014e                  2015e                          2013e                  2014e                    2015e
Sales                                                8,347                 8,391             8,643                  8,946                             0.5                    3.0                      3.5
Operating Costs                                     (6,922)               (6,985)           (7,173)                (7,379)                            0.9                   2.7                       2.9
EBITDA                                               1,425                 1,406             1,470                  1,566                            -1.3                    4.5                      6.5
Depreciation & Amortization                           (457)                 (445)             (458)                  (474)                           -2.6                   3.0                       3.5
EBIT                                                   968                   961             1,012                  1,092                            -0.7                    5.2                      7.9
Interest Expense                                      (105)                  (88)              (91)                   (94)                          -16.1                   3.0                       3.5
Pre-Tax Income                                         863                   873               921                    998                             1.1                   5.5                       8.4
Income Tax                                            (285)                 (309)             (320)                  (342)                            8.4                   3.4                       6.9
Net Income                                             578                   564               601                    656                            -2.4                   6.6                       9.2
EPS                                                    578                   560               599                    659                            -3.0                   7.0                     10.0

                                                                           Ratios (%)                                                                       YoY Change (bp)
                                                    2012e                 2013e              2014e                     2015e                       2013e            2014e                          2015e
EBITDA Margin                                         17.1                  16.8               17.0                      17.5                        -32                25                            50
EBIT Margin                                           11.6                  11.5               11.7                      12.2                        -15                25                            50
Pre-Tax Income Margin                                10.3                  10.4               10.7                      11.2                           6                25                            50
Net Income Margin                                      6.9                   6.7                7.0                       7.3                        -21                58                            43
Tax Rate                                              33.1                 35.4                34.7                      34.3                        237               -69                           -48
Buyback (Issuance) Yield                                                    -0.6                0.4                       0.8
Source: MSCI, IBES, ModelWare, Morgan Stanley Research
Note: MSCI Europe ex Financials P&L based on the aggregated data for 325 non-Financial companies in MSCI Europe index. All data converted from local currency at current spot rates, hence the
growth data represents the local currency (FX neutral) growth rate. EPS index data is for MSCI Europe index in local currency terms, Bloomberg ticker MSDLE15 Index.


Exhibit 8
MSCI Europe EPS Growth Estimates
                                                               Contribution To EPS Index                                                               Earnings Growth (%)
                                                    2012e             2013e          2014e                             2015e                       2013e          2014e                            2015e
MSCI Europe ex Financials                            73.8              71.6            76.6                              84.2                        -3.0            7.0                             10.0
MSCI Europe Financials                                20.1             23.3            26.8                              29.5                        16.0           15.0                             10.0
MSCI Europe                                          93.9              94.9           103.4                             113.7                         1.0            9.0                             10.0
Source: MSCI, IBES, ModelWare, Morgan Stanley Research
Note: MSCI Europe ex Financials P&L based on the aggregated data for 325 non-Financial companies in MSCI Europe index. All data converted from local currency at current spot rates, hence the
growth data represents the local currency (FX neutral) growth rate. EPS index data is for MSCI Europe index in local currency terms, Bloomberg ticker MSDLE15 Index.




                                                                                                                                                                                                            4
                                                                     MORGAN                     STANLEY                   RESEARCH

                                                                     September 4, 2013
                                                                     European Strategy




In contrast to our own top-down EPS growth forecasts,                Exhibit 9

bottom-up estimates by MS analysts are for growth of -3%,            MS GDP forecasts weighted by geographical
13% and 11% for 2013 through 2015. These compare to IBES             revenue exposure – UK version
consensus bottom-up forecasts of -2%, 13% and 11%,                                        UK
                                                                                      Company's                                                         Contribution To Revenue-Weighted
respectively. Note that IBES consensus EPS growth for the                              Revenue
                                                                                        Split %       2012
                                                                                                            Real GDP Growth (%)
                                                                                                               2013     2014    2015                    2012
                                                                                                                                                            Global Real GDP Growth (%)
                                                                                                                                                                   2013    2014     2015
median stock in Europe is 3%, 11% and 11% respectively.              UK
                                                                     Europe x UK
                                                                                          26.2
                                                                                          15.2
                                                                                                       0.2
                                                                                                       -0.5
                                                                                                                1.4
                                                                                                               -0.5
                                                                                                                         2.4
                                                                                                                         0.9
                                                                                                                                 2.1
                                                                                                                                 1.2
                                                                                                                                                         0.1
                                                                                                                                                         -0.1
                                                                                                                                                                    0.4
                                                                                                                                                                   -0.1
                                                                                                                                                                            0.6
                                                                                                                                                                            0.1
                                                                                                                                                                                     0.5
                                                                                                                                                                                     0.2
                                                                     US                   19.1         2.8      1.6      2.7     2.6                     0.5        0.3     0.5      0.5
                                                                     Asia ex Japan        17.8         6.2      6.0      5.9     6.1                     1.1        1.1     1.1      1.2
                                                                     Australia             1.3         3.6      2.6      2.6     2.7                     0.0        0.0     0.0      0.0
UK EPS outlook                                                       Japan                 2.7         2.0      1.6      1.3     1.3                     0.1        0.0     0.0      0.0
                                                                     LatAm                 5.5         2.8      2.8      3.0     3.0                     0.2        0.2     0.2      0.2
In Exhibit 9 we show the UK version of our revenue-weighted          CEEMEA               12.2         2.7      2.5      3.6     3.7                     0.3        0.3     0.4      0.5
                                                                     Revenue-Weighted Global GDP Growth
global GDP growth table. This suggests that the UK stock             Real
                                                                     Nominal
                                                                                                       2.2
                                                                                                       5.6
                                                                                                                2.2
                                                                                                                5.4
                                                                                                                         3.1
                                                                                                                         6.1
                                                                                                                                 3.1
                                                                                                                                 6.0
                                                                                                                                                            2.2
                                                                                                                                                            5.6
                                                                                                                                                                        2.2
                                                                                                                                                                        5.4
                                                                                                                                                                                    3.1
                                                                                                                                                                                    6.1
                                                                                                                                                                                               3.1
                                                                                                                                                                                               6.0
market should enjoy a better revenue and profit environment
                                                                     Source: Morgan Stanley Research Estimates
this year and next year with its real revenue-weighted GDP
growth figure of 2.2% in 2013 and 3.1% in 2014 comparing to
1.6% and 2.6% for the overall European market.                       Exhibit 10
                                                                     Our UK EGLI points to 6% EPS growth over N12M
In Exhibit 10 we introduce a new UK version of our European
                                                                      80
EGLI model designed to predict EPS growth over the coming
12m from two macro inputs – OECD global leading indicator             60

and the spread between RPI and PPI (as a proxy for margins)
                                                                      40
in the UK. Although its track record is not quite as strong as our
European version, it nevertheless has had reasonable success          20
at predicting subsequent EPS growth for the UK market.
                                                                       0

Top-down UK EPS growth forecasts are 1% for 2013 and
                                                                     -20
9% for 2014
In our Spring Update we raised our 2013 EPS growth for the           -40
                                                                                          Actual YoY EPS Growth %
FTSE from 6% to 9%, driven by our FX strategists’ bearish view                            Predicted YoY EPS Growth %
                                                                     -60
on GBP. Post more material EPS weakness in 1H13 than                       69   71   73    75   77   79   81   83   85   87   89   91   93   95   97   99     01   03     05   07    09   11    13
expected (particularly from the commodity sectors that have a
                                                                     Source: MSCI, ONS, OECD, Stanley Research
high weighting in the UK) and given a new, less bearish GBP
profile from our FX strategists, we have cut our 2013 UK EPS
growth forecast significantly. In fact, we have decided to set our
UK EPS growth forecasts to the same level as our wider
pan-European estimates at 1%, 9% and 10% for 2013-2015.
Although our revenue-weighted global GDP growth model
points to a better top-line environment for UK companies
overall, we note that UK profitability is considerably higher than
for the rest of Europe; hence, it is likely to provide less
operational leverage to the upside. Further, our FX strategists
now see EURGBP being broadly unchanged over the next 12
months.

Note that EPS estimates by MS analysts are for growth of -3%,
10% and 9% for 2013 through 2015. These compare to IBES
consensus bottom-up forecasts of -2%, 10% and 9%,
respectively. Note that IBES consensus EPS growth for the
median stock in the UK is 5%, 8% and 9%, respectively.




                                                                                                                                                                                                     5
                                                                                                                            MORGAN                                                                                      STANLEY                            RESEARCH

                                                                                                                            September 4, 2013
                                                                                                                            European Strategy




EPS growth exiting this recession to be lower than in prior                                                                 Exhibit 12

recoveries                                                                                                                  Operational leverage is likely to be limited given that
Before we move on to discuss the outlook for equity valuations,                                                             net income margins are reasonably high
it is worth asking why we expect only moderate EPS growth                                                                                                                                  25                                                                                                                               0

coming out of a recession. Traditionally, European EPS growth




                                                                                                                                                                                                                                                                                                                                MSCI Europe ex-Financials Net Income Margins, %
                                                                                                                             MSCI Europe Average of Next 5Y EPS Growth
                                                                                                                                                                                           20                                                                                                                               1
usually exceeds 30% or more as the region exits recession.                                                                                                                                                                       Subsequent 5Y EPS Growth

However, we believe such a rebound is unlikely to occur this                                                                                                                               15
                                                                                                                                                                                                                                                                                                                            2

time for three reasons.                                                                                                                                                                                                                                                                                                     3
                                                                                                                                                                                           10
                                                                                                                                                                                                                                                                                                                            4
1) Our economists forecast only a modest rebound in GDP
                                                                                                                                                                                           5
growth, reflecting the persistence of some of Europe’s                                                                                                                                                                                                                                                                      5

structural issues and continued headwinds from bank                                                                                                                                        0
                                                                                                                                                                                                                                                                                                                            6
deleveraging and tight fiscal policy.
                                                                                                                                                                                           -5                                                                                                                               7
                                                                                                                                                                                                                                                       Net Income Margins (RHS, inverted)
2) European EPS has not fallen significantly over the last                                                                                                                       -10                 Note: Dotted black line is factset estimates forecast for 2013                                                         8
couple of years and hence offers less scope for a large                                                                                                                                         1982                   1987                 1992                 1997              2002           2007            2012

rebound. For example, trailing EPS for MSCI Europe is                                                                       Source: MSCI, Worldscope, Factset estimates, Morgan Stanley Research
currently down 10% YoY versus an average 30% YoY decline                                                                    Exhibit 13

in prior downturns (Exhibit 11).                                                                                            European profitability is not as depressed as
                                                                                                                            coming out of previous recessions
3) Connected to point 2, current European margins are not                                                                                                                             22
particularly low relative to other recessions. As illustrated in                                                                                                                                                                                                                                MSCI Europe ex-
                                                                                                                                                                                      20
Exhibit 12, this suggests that the scope for a large rebound in
profitability/ operational leverage is more modest than coming                                                                                                                        18
                                                                                                                                                                                                                                                                                     Median Stock
out of prior recessions. While ROE is more depressed than
                                                                                                                             Trailing ROE (%)




                                                                                                                                                                                      16
margins, this partly reflects low profitability for a few sectors
such as financials, commodities and utilities. Exhibit 13 shows                                                                                                                       14

that ROE for the market ex financials is 3 percentage points                                                                                                                          12
higher than for the overall market and above its long-run
                                                                                                                                                                                      10
average. ROE for the median stock is currently 12.9%,
                                                                                                                                                                                                                                                                                                           MSCI Europe
moderately below its post 2000 average of 14.2% (based on                                                                                                                                  8

current constituents).
                                                                                                                                                                                           6
                                                                                                                                                                                                74       76     78     80      82     84      86     88     90        92   94   96    98   00    02   04   06     08   10   12
Exhibit 11
                                                                                                                            Source: MSCI, Morgan Stanley Research
European EPS – a smaller contraction in this
recession means less of a rebound                                                                                           Exhibit 14
                                                                                                                            Earnings are still 30% below prior peaks, but this is
                                         60                                                                                 only 15% excluding financials
                                         40                                                                                                                                                     0
  European Trailing EPS Growth YoY (%)




                                         20                                                                                                                                                -10
                                                                                                                                                   Distance From Historical Peak EPS (%)




                                          0                                                                                                                                                -20



                                         -20                                                                                                                                               -30



                                         -40                                                                                                                                               -40



                                         -60                                                                                                                                               -50
                                           Dec-70   Dec-75   Dec-80   Dec-85   Dec-90   Dec-95   Dec-00   Dec-05   Dec-10                                                                                        MSCI Europe
                                                                                                                                                                                                                 MSCI Europe ex Financials
                                                                                                                                                                                           -60
Source: MSCI, Morgan Stanley Research
                                                                                                                                                                                                    70    72 74 76           78 80         82 84       86 88          90   92 94     96 98   00 02    04 06 08         10 12


                                                                                                                            Source: MSCI, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                                                                                  6
                                                                           MORGAN                                                                               STANLEY                          RESEARCH

                                                                           September 4, 2013
                                                                           European Strategy




                                                                           Exhibit 15
#2 Can the PE ratio rise further?                                          MSCI Europe has just enjoyed a substantial 12m PE
Europe has just enjoyed a 40% re-rating over the last 2Y…                  re-rating over the last two years
Given that we believe the profit outlook for European stocks is                                                                         60

going to start improving soon, the next question is, is this
already reflected in the price? This is a particularly pertinent                                                                        40




                                                                            MSCI Europe - N12M P/E, 2yr % Chg
question given that we have seen one of the biggest re-ratings
                                                                                                                                        20
in Europe’s 12m PE over the last two years, as illustrated in
Exhibit 15.
                                                                                                                                         0


… and its PEG ratio is above average and ‘recovery’ years
                                                                                                                                        -20
One way to consider this is to compare the current valuation
against expected earnings growth. Exhibit 16 shows a PEG                                                                                -40

ratio for MSCI Europe where we divide trailing PE by
consensus expected EPS growth over the next 12m. As                                                                                     -60
                                                                                                                                              89        91       93      95            97        99         01    03    05        07         09         11            13
illustrated, while this ratio is not at the top of the historical range,
the current reading of 1.6 is above both the long-run average of           Source: MSCI, IBES, Morgan Stanley Research

1.3 and levels seen coming out of prior recessions such as the             Exhibit 16
early 1990s and 2003 (the ratio is distorted in 2009 as                    At 1.6, Europe’s PEG is above the long-run average
consensus 12m growth turned negative for the first time in                 and other ‘recovery’ years such as 1993 & 2004
history).
                                                                             MSCI Europe PEG Ratio - L12M PE (IBES) / N12M EPS Growth




                                                                                                                                         3.0


51% of European companies are expensive relative to
                                                                                                                                         2.5
their own history – highest since 2007
Another way to consider this question is shown in Exhibit 17                                                                             2.0
where we highlight the number of companies in the market that
are expensive relative to their own history (where their 12m PE                                                                          1.5
                                                                                                                                                                        Average
is in the top tertile relative to the last 7.5 years). As illustrated,
since 2000 the current reading of 51% is above the peak                                                                                  1.0

readings seen in 2003/4 and 2009. Since the bursting of the
equity bubble in 2001/2, the only period when this ratio has                                                                             0.5

been higher than now was for three months in 2007.
                                                                                                                                         0.0
                                                                                                                                               88       90       92      94            96        98        00    02    04    06         08         10        12
Traditional PE metrics are in-line with historical averages
                                                                           Source: MSCI, IBES, Morgan Stanley Research
While the above points suggest that equity valuations are now
high, more traditional valuation metrics are less extended. For            Exhibit 17

example, MSCI Europe’s trailing and 12m forward PE are                     51% of stocks are expensive relative to their own
in-line with long-term averages, as are valuations for UK                  history – highest since 2007
equities. Given it is common for equity valuations to move to                                                                                 60              % of Stocks where N12M PE is in the Top (Expensive)                                                 25
                                                                                                                                                              Tertile Relative to its 7.5Y History Each Month
                                                                            % of Stocks where N12M PE is in the Top (Expensive)




above average levels as economies exit recession, it is                                                                                                       MSCI Europe - N12M PE (RHS)                                                                         23
                                                                               Tertile Relative to its 7.5Y History Each Month




important to consider what causes equity valuations to peak                                                                                   50
                                                                                                                                                                                                                                                                  21
out and roll over in such situations.
                                                                                                                                                                                                                                                                       MSCI Europe - N12M PE




                                                                                                                                                                                                                                                                  19
                                                                                                                                              40
                                                                                                                                                                                                                                                                  17
As economies exit recessions the PE ratio tends to rise
until inflation troughs                                                                                                                       30                                                                                                                  15


Having analysed various macro indicators, we conclude that                                                                                                                                                                                                        13
                                                                                                                                              20
the key dynamic is inflation. Exhibit 18 shows how troughs in                                                                                                                                                                                                     11

inflation post prior recessions usually coincide with an end to                                                                                                                                                                                                   9
                                                                                                                                              10
PE expansion (and vice versa). Note, that such an event does                                                                                                                                                                                                      7
not end the bull market for stocks; however, the key driver
                                                                                                                                               0                                                                                                                  5
changes from multiple expansion to EPS growth.                                                                                                     00    01      02    03         04        05        06    07   08    09    10        11     12        13


                                                                           Source: MSCI, Factset, Morgan Stanley Research




                                                                                                                                                                                                                                                                                               7
                                                                           MORGAN                                                 STANLEY                 RESEARCH

                                                                           September 4, 2013
                                                                           European Strategy




History suggests the PE ratio is more sensitive to inflation               Exhibit 18

than bond yields…                                                          A trough in CPI usually prompts a rollover in the PE
This point is key in the ongoing debate as to the impact of                                                       18                                                                                         35
                                                                                                                                                                            Inflation Rate
higher bond yields on equity performance. Logically, there is a                                                   16
                                                                                                                                                                            MSCI Europe Trailing P/E (RHS)
                                                                                                                                                                                                             30
close relationship between bond yields and inflation when                                                         14




                                                                            Europe (EU16) Inflation (YoY % Chg)
viewed over the long term; however, when the two diverge our




                                                                                                                                                                                                                  MSCI Europe - Trailing P/E
                                                                                                                  12                                                                                         25
analysis suggests that equity valuations are more sensitive to
                                                                                                                  10
the latter than the former. For example, Exhibits 19-22 plot                                                                                                                                                 20

                                                                                                                   8
inflation, bond yields and PE ratios during prior ‘post recession’
                                                                                                                                                                                                             15
periods and on every occasion the peak in the PE occurred                                                          6

closer to the trough in inflation than the trough in bond yields. In                                               4                                                                                         10

fact, across all periods with the exception of the early 1990s                                                     2
                                                                                                                                                                                                             5
(when they were coincident), bond yields had started rising                                                        0

before inflation troughed and during these phases the PE ratio                                                    -2                                                                                         0
continued to rise.                                                                                                     70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12


                                                                           Source: MSCI, Datastream, Various National Sources, Morgan Stanley Research
… hence higher bond yields are not necessarily bad for
                                                                           Exhibit 19
equities until inflation starts to rise                                    In the early 1980s, Europe’s PE stalled once inflation
This analysis also suggests that as long as inflation stays low            troughed (and after bond yields troughed)
equities should not suffer a large negative impact from any
moderate increase in bond yields. While we should be wary of                                                       14
                                                                                                                                                                          MSCI Europe trailing PE (RHS)
                                                                                                                                                                                                             14

drawing too heavily on historical comparisons, we find the                                                         13
                                                                                                                                                                                                             13
1950s and 1960s of interest when considering the impact of                                                                      EU Inflation Rate YoY
                                                                                                                   12




                                                                                                                                                                                                                  MSCI Europe - Trailing P/E
bond yields and inflation on equity valuations. As illustrated in
                                                                                                                                                                                                             12
Exhibit 23, from the early 1950s to the mid 1960s the PE ratio                                                     11

of US equities generally rose against a backdrop of slowly
                                                                             (%)




                                                                                                                   10                                                                                        11
rising bond yields. However, as inflation started to accelerate
                                                                                                                       9
from the mid-1960s bond yields rose more sharply and the PE                                                                                                                                                  10
ratio started to fall. The logic is likely to be that while inflation is                                               8
                                                                                                                                                                          10Y German Yield
low investors are not that concerned about the risks of a                                                                                                                                                    9
                                                                                                                       7
sustained and large move higher in bond yields; however, that
confidence starts to erode once inflation picks up.                                                                 6                                                                                        8
                                                                                                                    Jan-82       Jul-82        Jan-83        Jul-83         Jan-84         Jul-84


Our economists forecast CPI to trough soon and then to                     Source: MSCI, Datastream, OECD, Morgan Stanley Research

slowly rise                                                                Exhibit 20
This inverse relationship between the PE ratio and inflation has           In the early 1990s, the peak in Europe’s PE
been relatively constant over the very long-term (Exhibit 24)              coincided with a trough in inflation and bond yields
and also in the last few years (Exhibit 25) – it has also been true
                                                                                                                  10.0                                                                                       18
in Japan for the decade despite a deflationary backdrop. In
                                                                                                                   9.5
Exhibit 26, we plot the CPI forecasts for Europe and the UK and                                                                  EU Inflation Rate YoY
                                                                                                                                                                                                             17

                                                                                                                   9.0
both show inflation troughing in 3Q13 before rising modestly                                                                                                                                                 16
thereafter. Such a profile is not particularly conducive to further                                                8.5
                                                                                                                                                                                                                     MSCI Europe - N12M P/E




                                                                                                                                                                                                             15
multiple expansion from here, although the lack of a                                                               8.0
                                                                            (%)




meaningful rise in inflation over the next year or so also points                                                  7.5                                                                                       14

to no sustained contraction in valuations.                                                                         7.0
                                                                                                                                                                                                             13

                                                                                                                   6.5
                                                                                                                                                                                                             12
                                                                                                                   6.0                                                                 10Y German Yield

                                                                                                                                 MSCI Europe trailing PE (RHS)                                               11
                                                                                                                   5.5

                                                                                                                   5.0                                                                                       10
                                                                                                                      Jan-92      Jul-92         Jan-93          Jul-93       Jan-94         Jul-94


                                                                           Source: MSCI, Datastream, OECD, Morgan Stanley Research




                                                                                                                                                                                                                                               8
                                                                                                                                                               MORGAN                                         STANLEY                  RESEARCH

                                                                                                                                                               September 4, 2013
                                                                                                                                                               European Strategy




Exhibit 21                                                                                                                                                     Exhibit 24
In the early 2000s, Europe’s PE stalled once inflation                                                                                                         In the long-run equity valuations move in an inverse
troughed (and after bond yields troughed)                                                                                                                      direction to inflation
       7                                                                                                18                                                                                40


                                                                                                        17
       6                                                                                                                                                                                  30

                                                                                                        16                                                                                                                                                   S&P Trailing PE




                                                                                                             MSCI Europe - N12M P/E




                                                                                                                                                                10-year rolling average
       5                                                                                                                                                                                  20
                                                                                                        15
                                                                             10Y German Yield
 (%)




       4                                                                                                14                                                                                10


                                                                                                        13
       3                                                                                                                                                                                   0
                                                                                                                                                                                                                                                       US CPI Inflation
                                                                                                        12

       2                                                                                                                                                                                  -10
                                                                     EU Inflation Rate YoY              11
                  MSCI Europe trailing PE (RHS)

       1                                                                                                10                                                                                -20
        Jan-02          Jul-02      Jan-03           Jul-03          Jan-04             Jul-04                                                                                              1900       1910   1920     1930    1940         1950     1960    1970     1980      1990     2000     2010


Source: MSCI, Datastream, OECD, Morgan Stanley Research                                                                                                        Source: Global Financial Data, BLS, S&P, Shiller, Morgan Stanley Research

Exhibit 22                                                                                                                                                     Exhibit 25
In 2009, the peak in Europe’s PE coincided with a                                                                                                              PE ratio has close (inverse) relationship with CPI
trough in inflation
                                                                                                                                                                                          14                                                                                                         0.0
       5.0                                                                                                  14                                                                                      EU inflation (RHS, inverted)
                                                                                                                                                                                                                                                                                                     0.5
                                                                  MSCI Europe trailing PE (RHS)                                                                                           13
       4.5
                                                                                                            13                                                                                                                                                                                       1.0
                                                                                                                                                                                                                                                                MSCI Europe 12m PE
       4.0                                                                                                                                                                                12                                                                                                         1.5
                                                                                                            12
                                                                                                                                                                  MSCI Europe 12m PE




                                                                                                                                                                                                                                                                                                           EU CPI Inflation
       3.5
                                                                                                                                      MSCI Europe - N12M P/E




                                                                                                                                                                                                                                                                                                     2.0
                                                                                                                                                                                          11
                                                                                                            11
       3.0
                                                                                                                                                                                                                                                                                                     2.5
 (%)




       2.5                                                                                                  10                                                                            10
                                                                                                                                                                                                                                                                                                     3.0

       2.0                                                                           10Y German Yield                                                                                                                                                                                                3.5
                                                                                                            9                                                                              9
       1.5                                                                                                                                                                                                                                                                                           4.0
                                                                                                            8
                                                                                                                                                                                           8
       1.0                                                                                                                                                                                                                                                                                           4.5
                                                                       EU Inflation Rate YoY
                                                                                                            7
       0.5                                                                                                                                                                                 7                                                                                                       5.0
                                                                                                                                                                                           Sep-08             Sep-09               Sep-10              Sep-11               Sep-12            Sep-13
       0.0                                                                                                  6
        Jan-08          Jul-08      Jan-09           Jul-09           Jan-10            Jul-10
                                                                                                                                                               Source: MSCI, Datastream, IBES, Morgan Stanley Research
Source: MSCI, Datastream, OECD, Morgan Stanley Research
                                                                                                                                                               Exhibit 26
Exhibit 23                                                                                                                                                     Our economists forecast a modest rise in inflation
In the 1950s and 1960s equity valuations held up                                                                                                               over the N6M
despite modest increase in bond yields – it took
                                                                                                                                                                                           4.0
higher inflation from 1965 to hurt PE ratios
                                                                                                                                                                                                                                                             MS Forecasts

       8                                                                                                24                                                                                 3.5
                                                              S&P 500 PE (RHS)
       7
                                                                                                        22
                                                                                                                                                                                           3.0                                                                                                  UK
       6
                                                                                                                                                                  CPI Inflation (%)




                 10Y UST yield                                                                          20
       5
                                                                                                                                                                                           2.5
                                                                                                                            S&P Trailing PE




                                                                                                        18
       4
 (%)




       3                                                                                                16
                                                                                                                                                                                           2.0

       2
                                                                                                        14
                                                                                                                                                                                                                                                                                              EMU
       1                                                                                                                                                                                   1.5
                                                                                                        12
       0

                                                                                                        10                                                                                 1.0
       -1
                                                                         US inflation, YoY%                                                                                                   Jan-12          Jul-12          Jan-13               Jul-13          Jan-14            Jul-14
       -2                                                                                               8
         1952    1954       1956    1958      1960        1962        1964       1966        1968                                                              Source: ONS, Eurostat, Morgan Stanley Research Forecasts

Source: Global Financial Data, Datastream, S&P, Shiller, BLS, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                              9
                                                                       MORGAN                                         STANLEY                    RESEARCH

                                                                       September 4, 2013
                                                                       European Strategy




Other influences on equity valuations                                  is likely to be drawn out over a 6-12 month period during which
While inflation appears to have a significant influence on PE          QE will still be injecting liquidity into asset markets. On the
ratios, there are other metrics that have the potential to             basis that investing is about changes at the margin, we think
influence equity valuations. As we have written in previous            that the ongoing inflection point in US monetary policy is
reports (for example, ‘From Despair to Where – The Long-term           important for stocks and we note that Exhibit 33 shows how
outlook for EPS growth and equity valuation, 8 May 2012’),             equity valuations invariably de-rate as you get closer to the
these other metrics include earnings, geopolitics and liquidity.       start of a new tightening cycle.

Earnings trends may offer scope for further PE expansion               Exhibit 27

The relationship between the PE ratio and EPS trends can vary          Current 12m PE is consistent with consensus N12M
depending on where you are in the economic cycle; however,             EPS growth expectations…
in general PE ratios tend to rise in periods of stronger and less                                         20

volatile growth and vice versa. Exhibits 27 and 28 suggest that
                                                                                                          18
current valuations are broadly consistent, based on historical                                                       Current consensus EPSg                 Current PE = 12.5x
                                                                                                                    forecast is 8.5% over N12M
relationships, with forecast growth assumptions and current                                               16




                                                                                   12m PE - MSCI Europe
EPS volatility. Going forward, we believe it reasonable to
                                                                                                          14
assume that EPS growth expectations can improve modestly
while volatility is likely to remain on a downward trajectory – i.e.                                      12

EPS trends could imply a higher PE ratio.                                                                 10


                                                                                                           8
Geopolitics suggests slower pace of improvement in
Europe’s risk premium ahead                                                                                6
                                                                                                               <4       4 to 8      8 to 12      12 to 16   16 to 20      20 to 24   24 to 28     > 28
As illustrated in Exhibits 29-31, we have seen a significant
                                                                                                                             Level of YoY 12m Forward EPS Growth - MSCI Europe (%)
reduction in Europe’s risk premium over the last year or so that
has boosted equity valuations. In general, these metrics are           Source: MSCI, IBES, Morgan Stanley Research

now back to the levels they were before the Euro-zone crisis           Exhibit 28
escalated significantly in 3Q11. While there is scope for              … and trailing PE is consistent with current level of
Europe’s risk premium to come in further (these metrics are            EPS volatility
generally still quite high compared to pre-2010 levels and our
                                                                                                          20
bond strategists forecast further peripheral spread
                                                                                                                                      We are currently here...
compression), the pace of future improvement is likely to be                                              18

slower and dependent on both continued economic expansion
                                                                                                                                                                       … having fallen from here in 3Q12
and reforms to tackle some of Europe’s structural issues such                                             16
                                                                        MSCI Europe Trailing PE




as banking union and fiscal policy. In the context of Europe’s
                                                                                                          14
risk premium back at mid-11 levels, it is also worth noting that
Europe’s 12m PE is now comparable to where it was in 1H10                                                 12
(i.e., equities are arguably already pricing in a further
improvement in European risk premia).                                                                     10


                                                                                                          8
Liquidity – QE tapering may weigh on the PE short term,
but equity inflows may boost the PE longer term                                                           6
We tend to view the influence of liquidity dynamics on equities                                                < 10          10 to 15      15 to 20       20 to 25      25 to 30                > 30
                                                                                                                                    36-month St Dev of YoY EPS Growth (%)
through two areas – unconventional central bank policy and
                                                                       Source: MSCI, Morgan Stanley Research
equity inflows. Going forward we see these factors moving in
opposing directions.

QE tapering is likely to weigh on equity valuations
First, as illustrated in Exhibit 32, unconventional policy from the
Fed does appear to have had an influence on equity valuations
in recent years. In this regard, we believe that the process of
QE tapering is likely to put some downward pressure on equity
valuations, although the picture is complicated as the process



                                                                                                                                                                                                           10
                                                                                                                                                                  MORGAN                                                                     STANLEY                           RESEARCH

                                                                                                                                                                  September 4, 2013
                                                                                                                                                                  European Strategy




Exhibit 29                                                                                                                                                        Exhibit 32
Close fit between iTraxx SnrFin and MSCI Europe’s                                                                                                                 QE has likely had a positive influence on PE ratios
12m P/E                                                                                                                                                                                                              Fed announces    Fed announces further
                                                                                                                                                                                                                                                                                                                                          Op. Twist ends.
                                                                                                                                                                                                                                                                                                                                          QE3 purchases
                                                                                                                                                                                                                    $600bn purchase    purchase of $850bn             QE2 Flagged
                                                                                                                                                                                                                                                                       at Jackson QE2              QE2 Operation                    QE3 increased from
                                                                                                                                                                                                                     in agency MBS      agency MBS and         QE1
                                                                                                                                                                                                                                                                           Hole Starts             ends Twist starts               begins $40bn to $85bn
                      14                                                                                         0                                                                                                                     $300bn USTs (QE1)       ends
                                                                                                                                                                                                                    14

                                                                                                                 50
                      13

                                                iTraxx SnrFin (RHS, inverted)                                    100                                                                                                12




                                                                                                                        iTraxx Senior Financials CDS




                                                                                                                                                                   MSCI Europe N12M P/E
 MSCI Europe 12m PE




                      12
                                                                                                                 150

                                                                                                                                                                                                                    10
                      11                                                                                         200


                                                                                                                 250
                      10
                                                                                                                                                                                                                      8
                                                                                                                 300
                                 MSCI Europe N12M PE
                       9
                                                                                                                 350
                                                                                                                                                                                                                     6
                       8                                                                                         400                                                                                                 Sep-08      Mar-09       Sep-09          Mar-10      Sep-10         Mar-11       Sep-11           Mar-12          Sep-12    Mar-13
                       Jan-10     Jul-10      Jan-11      Jul-11      Jan-12        Jul-12    Jan-13    Jul-13
                                                                                                                                                                  Source: MSCI, IBES, Morgan Stanley Research
Source: Bloomberg, MSCI, IBES, Morgan Stanley Research
                                                                                                                                                                  Exhibit 33
Exhibit 30                                                                                                                                                        Equity valuations tend to peak out as we get closer
Peripheral bond spreads continue to narrow                                                                                                                        to the start of monetary tightening
                      14                                                                                         0                                                              30
                                                                                                                       Italy 10Y bond spread over Germany (bps)




                      13                   Italy 10Y bond spreads (RHS, inverted)                                100                                                            25



                                                                                                                                                                                20                                                                                                                                                            MSCI Europe PE
 MSCI Europe 12m PE




                      12                                                                                         200



                      11                                                                                         300                                                            15



                                                                                                                                                                                10
                      10                                                                                         400

                                                                                                                                                                                                                                                                                                                                              Fed Funds Rate
                                MSCI Europe N12M PE                                                                                                                                                         5
                      9                                                                                          500


                                                                                                                                                                                                            0
                      8                                                                                          600
                                                                                                                                                                                                                     72    74    76     78    80    82        84   86     88    90       92   94      96     98        00    02    04     06     08    10   12
                      Jan-10      Jul-10     Jan-11       Jul-11      Jan-12        Jul-12    Jan-13    Jul-13


Source: Bloomberg, MSCI, IBES, Morgan Stanley Research                                                                                                            Source: MSCI, Datastream, Morgan Stanley Research

Exhibit 31                                                                                                                                                        Exhibit 34
Any renewed increase in VSTOXX would likely                                                                                                                       European mutual fund equity inflows tend to
weight on equity valuations                                                                                                                                       correspond to a higher P/E
                      14                                                                                         10                                                                                                  30                                                                                                                                     24
                                                                                                                                                                   Euroepan Mutual Fund Equity Flows $Bn (3m Avg)




                                                                                                                                                                                                                                                                                                                                                            22
                                                                                                                 15
                                                                    VSTOXX (RHS, inverted)                                                                                                                           20
                      13
                                                                                                                                                                                                                                                                                                                                                            20
                                                                                                                 20
                                                                                                                                                                                                                                                                                                                                                                 MSCI Europe N12M PE
 MSCI Europe 12m PE




                                                                                                                       VSTOXX (5-Day Average)




                                                                                                                                                                                                                     10                                                                                                                                     18
                      12                                                                                         25

                                                                                                                                                                                                                                                                                                                                                            16
                                                                                                                 30
                                                                                                                                                                                                                      0
                      11                                                                                                                                                                                                                                                                                                                                    14
                                                                                                                 35
                                                                                                                                                                                                                    -10                                                                                                                                     12
                      10                                                                                         40
                                                                                                                                                                                                                                                                                                                                                            10
                                                                                                                 45                                                                                                 -20
                       9                                                                                                                                                                                                                                                                                                                                    8
                                                                                MSCI Europe N12M PE
                                                                                                                 50
                                                                                                                                                                                                                    -30                                                                                                                                     6
                       8                                                                                         55                                                                                                       96    97    98     99    00     01       02     03     04      05    06       07     08       09        10     11     12    13
                       Jan-10     Jul-10      Jan-11       Jul-11      Jan-12       Jul-12     Jan-13   Jul-13                                                                                                        Periods of Equity Inflows                    European MF Inflows to Equities                           MSCI Europe N12M PE (RHS)


Source: Bloomberg, MSCI, IBES, Morgan Stanley Research                                                                                                            Source: MSCI, IBES, Various National Sources, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                                                                                       11
                                                                      MORGAN        STANLEY       RESEARCH

                                                                      September 4, 2013
                                                                      European Strategy




Equity inflows should support the PE                                  assume no major re-escalation in the Euro-zone’s sovereign
One potential offset to the ending of QE is an asset allocation       debt crisis over the next year. A more normal DM macro
shift in favour of equities. While we believe a ‘great rotation’ is   environment should also provide a degree of stability to the EM
unlikely, we do believe equities are the most attractive asset        macro landscape too.
class over the longer term and that net equity flows are more
likely to be positive rather than negative going forward. This        In-line with our economists’ GDP forecasts and our own
should be supportive to equity valuations in general. Exhibit 34      top-down earnings models, we assume MSCI Europe’s EPS
shows how the PE ratio tends to rise in periods of such inflows.      growth profile is 1% in 13, 9% in 14, 10% in 15. We leave our
Note that the chart shows the 3-month moving average which            12m PE assumption unchanged at 12.5 (note that the median
remains negative, although the latest monthly data point is now       reading since 1987 is 12.7). Based on these assumptions we
in positive territory. Anecdotally we are seeing more interest        upgrade our 12m rolling ‘base case’ price target on MSCI
and inflows into Europe than this chart would suggest (e.g.           Europe to 1380.
flows into European ETFs have risen sharply over the last
                                                                      Bull case – ‘Goldilocks redux’
couple of months).
                                                                      Over the next 6-12 months the bull case for stocks is unlikely to
Most factors have been ‘tailwinds’ for equity valuations in           be driven by very strong GDP growth as that would likely usher
the last 18m…                                                         in more overt concerns around the pace of monetary stimulus
At the beginning of this section we flagged that the 2-year           withdrawal and a more sustained move to higher rates. While
change in Europe’s 12m PE was very high versus history.               positive for EPS this could be offset by lower PE ratios. Instead,
Looking through the various factors that influence the PE this is     a bull case would likely involve a moderate pick up in economic
understandable given that most have been generating upward            activity yet continued aggressive monetary policy
pressure on equity valuations. For example, weak inflation has        accommodation from central banks. Other catalysts for a bull
negated fears over higher bond yields, QE has provided a              case outcome for stocks could include a large pick up in equity
positive liquidity backdrop, Europe’s risk premium has been           inflows and/or a rebound in M&A activity, both of which would
declining for 18 months, and earnings volatility has been falling     put upward pressure on valuations.
(even though there has been no EPS growth).
                                                                      Putting our economists’ bull case GDP forecasts into our
… however the forward outlook is more mixed                           top-down model suggests European EPS growth of 3% this
Looking forward these factors are likely to create a more mixed       year, followed by 15% in 2014 and 15% in 2015. We maintain
backdrop for equity valuations. On the negative side inflation is     our bull case 12m PE assumption at 13.5, which is consistent
unlikely to fall further and QE tapering will likely exert some       with the peak multiple seen on this metric since 2003 and is
downward pressure on equity valuations. On the positive side,         also equal to the average reading since the data starts in 1987.
earnings trends should be improving, Europe’s risk premium            Based on these assumptions we upgrade our 12m rolling ‘bull
continues to decline (albeit at a slower pace), asset allocation      case’ price target on MSCI Europe to 1654.
shifts should favour equities, and inflation, while troughing, is
                                                                      Bear case – ‘weaker EM growth or higher US rates’
not expected to rise meaningfully.
                                                                      Together, Morgan Stanley economists and strategists believe
We keep our 12m PE ‘fair value’ estimate at 12.5                      that the most likely sources of downside risk currently come from
As a result of the above we have decided to keep our ‘fair            either an economic growth disappointment out of EM or a higher
value’ assumption for MSCI Europe unchanged at a 12m PE of            than expected rise in (US) bond yields. The former would weigh
12.5. This compares to current IBES consensus valuation of            on the outlook for European EPS growth given that 1/3 of
12.5 for MSCI Europe’s 12m PE (i.e. the same as our target)           revenues come from EM + Rest of World and that these same
and a 12m PE of 14 for the median stock in the market.                regions have accounted for between 65-90% of revenue growth
                                                                      for European companies in the last few years. A higher than
In conjunction with the above analysis on EPS and PE trends           expected rise in US bond yields would likely hurt equities
we are making some changes to our bull, base and bear case            through a lower PE ratio. While EM equities would likely be hurt
scenarios and associated price targets as follows.                    the most by higher US yields, Europe’s weak GDP outlook
                                                                      means that it can ill afford a significant increase in its own
Base Case – ‘DM normalisation’                                        funding costs at this time. If this were to occur we think the ECB
In our base case we assume that the DM macro outlook                  would likely move to ease policy further. Other catalysts for a
continues to look a little more ‘normal’ as DM economies              bear case outcome for stocks could include a re-escalation of
continue their recovery (to moderate growth), unconventional          the euro-zone sovereign debt crisis or a significant appreciation
monetary policy fades and bond yields drift higher. We also           in the oil price on geopolitical concerns.



                                                                                                                                           12
                                                                                                   MORGAN          STANLEY             RESEARCH

                                                                                                   September 4, 2013
                                                                                                   European Strategy




Putting our economists’ bear case GDP forecasts into our                                           Tactical risk-reward outlook less constructive…
top-down model suggests European EPS growth of -1% this                                            Although we are raising our 12-month index target in this report,
year, followed by -5% in 2014 and 0% in 2015. We have                                              we do believe that the tactical risk-reward outlook is more
decided to modestly raise the 12m PE assumption in our bear                                        negative as we wrote in our recent report Sellers’
case to 11 (up from 10.5) to reflect the view that the ongoing                                     Compendium: Sell screens support our tactical caution‘ 19
improvement in Europe’s macro data makes a severe                                                  August 2013. Our near-term caution reflects concerns around
escalation of the sovereign debt crisis less likely in the coming                                  a number of observations including: a likely rollover in
months. Based on these assumptions we upgrade our 12m                                              economic surprise indices; recently elevated sentiment and
rolling ‘bear case’ price target on MSCI Europe to 971.                                            risk appetite; our MTI above 0SD (which has been a good sell
                                                                                                   signal in this cycle); an oil price approaching $120 (that has
PRICE TARGET – ‘Probability weighted average’                                                      tended to be the threshold for weaker equity performance in
MSCI Europe index target = 1350, implying 7% upside                                                recent years); and a number of potential risk events around QE
We set our price target based on a weighted average of the bull,                                   tapering, Bernanke’s replacement, the German election and
base and bear cases. We assume weightings of 60% for the                                           the German Constitutional Court ruling on the OMT.
base case, 20% for the bull case and 20% for the bear case. As
illustrated in Exhibit 35, this methodology results in a                                           … but medium-term outlook is still positive
probability-weighted price target of 1350.                                                         These short-term concerns predominantly reflect fears around
                                                                                                   sentiment, valuation and positioning. Looking further out we
FTSE100 target rises to 7170                                                                       believe the macro backdrop for stocks remains a positive one
As we discussed on page 5, we have cut our 2013 UK EPS                                             given the likelihood of an improving economic cycle and equity
growth forecast for the FTSE to 1% from +9%, reflecting weak                                       valuations that are relatively attractive compared to other asset
earnings in 1H13 (especially due to the commodity sectors)                                         classes. The key investment themes we discuss next are
and a less bearish forecast for GBP from our FX strategists. As                                    predominantly predicated on a 6m outlook and we would look
illustrated in Exhibit 36 applying a 12m PE of 12.2 for the UK                                     to increase exposure to these areas during any correction.
(which traditionally trades at a slight discount to Europe) to our
EPS profile points to a probability weighted FTSE100 of 7170
(previously 7000).

Exhibit 35
MSCI Europe Index Targets
                          Probability                                      EPS                                             EPS Growth (%)             PE       Index     Implied
                          Weight (%)       2012e       2013e       2014e         2015e     N12M        N24M        2013e       2014e      2015e   (N24M EPS)   Target   Upside (%)
Base                          60            93.9        94.9       103.4         113.7     100.6       110.4         1           9         10        12.5      1,380        9.6
Bear                          20            93.9        93.0        88.3          88.3      89.8        88.3         -1          -5         0        11.0       971       -22.9
Bull                          20            93.9        96.7       111.2         127.9     106.5       122.5         3           15        15        13.5      1,654       31.4
Probability Weighted                                                                                                                                           1,350        7.2

Source: MSCI, IBES, Morgan Stanley Research
Note: Index targets correspond to the MSCI Europe index in local currency terms (Bloomberg ticker MSDLE15 Index)

Exhibit 36
FTSE 100 Index Targets
                          Probability                                      EPS                                             EPS Growth (%)             PE       Index     Implied
                          Weight (%)       2012e       2013e       2014e         2015e     N12M        N24M        2013e       2014e      2015e   (N24M EPS)   Target   Upside (%)
Base                          60           507.7       512.9       558.9         614.8     544.0       596.7         1           9         10        12.3      7,310       12.4
Bear                          20           507.7       502.6       477.5         477.5     485.6       477.5         -1          -5         0        10.8      5,147      -20.9
Bull                          20           507.7       522.9       601.3         691.5     576.0       662.4         3           15        15        13.2      8,763       34.7
Probability Weighted                                                                                                                                           7,170       10.2

Source: FTSE, IBES, Morgan Stanley Research




                                                                                                                                                                                     13
                                                                                                                                                        MORGAN                                                                  STANLEY             RESEARCH

                                                                                                                                                        September 4, 2013
                                                                                                                                                        European Strategy




#1 OW Value stocks (with growth)                                                                                                                        outlook. For example, Exhibit 60 provides a stock screen that
                                                                                                                                                        looks for stocks that trade on a PE below 13, a dividend yield of
Since early May we have been recommending investors
                                                                                                                                                        over 3% (both trailing ratios) and where consensus expects an
overweight Value stocks relative to Growth stocks (see our
                                                                                                                                                        EPS CAGR of 6% or more over the next couple of years.
report Getting more positive on Value & Banks, 7 May 2013).
                                                                                                                                                        Overweight rated stocks on this list include: Mapfre, AXA,
Many of the arguments we made back then in favour of a
                                                                                                                                                        Investec, Aegon, RSA, Renault, Natixis, Imperial Tobacco,
rotation into Value are still valid today and hence we continue
                                                                                                                                                        Aviva and Snam.
to recommend investors stay overweight Value. For example:
                                                                                                                                                        Alternatively, we look for stocks that look cheap on normalized
i) The relative performance and valuation of ‘Value’ versus
                                                                                                                                                        earnings, with solid balance sheets (so they are less exposed
‘Growth’ are low relative to history (see Exhibits 37 and 38).
                                                                                                                                                        to higher rates) and a decent EPS profile. Exhibit 61 provides a
                                                                                                                                                        stock screen in this regard - Overweight rated stocks toward
ii) Valuation dispersion is wide compared to history as shown
                                                                                                                                                        the top of this list include: Renault, ENI, Veolia, Metro, ITV,
by the dark line in Exhibit 39. When compared to credit spreads
                                                                                                                                                        EADS, BHP Billiton, Petrofac, BG, SAP and Sanofi.
(the lighter blue line) the gap between the two series appears
wide versus history. Previous such ‘gaps’ occurred around                                                                                               Exhibit 38
2000, 1992 and the early 1980s and saw subsequent                                                                                                       The relative valuation of MSCI Europe Growth vs
outperformance of Value over Growth.                                                                                                                    Value indices is at the upper end of the range

iii) The ROE of MSCI Europe’s Value index appears to be rising                                                                                           180
relative to its Growth index (Exhibit 40).                                                                                                               160
                                                                                                                                                                                                                            % Premium / Discount
                                                                                                                                                                                                                            Average
                                                                                                                                                         140
iv) Improving economic indicators and higher bond yields
                                                                                                                                                         120
traditionally provide a positive backdrop for Value
                                                                                                                                                         100
outperformance (Exhibits 41 and 42).
                                                                                                                                                                                        80

However, the fact that bond yields are more likely to trend                                                                                                                             60

higher rather than lower going forward means that investors                                                                                                                             40

also need to be wary of Value stocks offering little or no growth.                                                                                                                      20

These bond proxy type stocks are vulnerable to rising bond                                                                                                                                                0
yields that will erode their relative yield attractiveness.                                                                                                                                                   75           80        85           90             95        00            05          10

Consequently, we prefer to focus on stocks that can be                                                                                                  Source: MSCI, Morgan Stanley Research
                                                                                                                                                        Note: Average relative valuation across PB, PE, PD and PCE. Note: MSCI Value and Growth
classified as Value and that have a reasonable EPS growth                                                                                               indices are constructed using eight historical and forward-looking fundamental data points.

Exhibit 37                                                                                                                                              Exhibit 39

On a sector neutral basis, cheap stocks have                                                                                                            Valuation dispersion remains wide – especially
outperformed expensive stocks in recent months                                                                                                          relative to credit spreads
                                                                                                                                                                                                          1.7                                                                                             800
                                                            140                                                                                                                                                                                                        US BBB credit spreads (RHS)
  Sector Neutral Performance Of Growth & Value Strategies




                                                                                                                                                                                                          1.6
                                                                                                                                                         Sector Neutral Valuation Dispersion (BV Yield)




                                                                                                                                                                                                                                                                                                          700
                                                            130
                                                                                                                                                                                                          1.5        European Valuation Dispersion (BV Yield)
                                                                                                                                                                                                                                                                                                          600
                                                                                                                                                                                                                                                                                                                US BBB Credit Spreads (bps)




                                                            120                                                                                                                                           1.4

                                                                                                                                                                                                                                                                                                          500
                                                                                                                                                                                                          1.3
                                                            110
                                                                                                                                                                                                          1.2                                                                                             400

                                                            100                                                                                                                                           1.1
                                                                                                                                                                                                                                                                                                          300

                                                                                                                                                                                                          1.0
                                                            90
                                                                                                                                                                                                                                                                                                          200
                                                                                                                                                                                                          0.9
                                                            80                                                                                                                                                                                                                                            100
                                                                      Cheap vs Expensive Stocks                                                                                                           0.8
                                                                      High Growth vs Low Growth Stocks
                                                            70                                                                                                                                            0.7                                                                                             0
                                                             Jan-09   Jul-09   Jan-10   Jul-10    Jan-11   Jul-11   Jan-12   Jul-12   Jan-13   Jul-13                                                           80    83        86    89     92        95       98    01    04      07        10     13


                                                                                                                                                        Source: MSCI, Moody’s, The Yield Book, Morgan Stanley Research
Source: Morgan Stanley Quantitative & Derivative Strategies, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                                              14
                                                                                                                                                                                                                 MORGAN                                                                   STANLEY                   RESEARCH

                                                                                                                                                                                                                 September 4, 2013
                                                                                                                                                                                                                 European Strategy




Exhibit 40                                                                                                                                                                                                       #2 OW Financials
Value’s ROE continues to outpace that of Growth                                                                                                                                                                  We continue to believe that Financials offer the most
        250                                                                                                                                                         0
                                                                                                                                                                                                                 interesting Value opportunities in the market and reiterate our
                                                              Relative performance of MSCI Europe Value vs Growth
                                                                                                                                                                                                                 overweight position. We cite four broad reasons to support this
                                                              Relative ROE of MSCI Europe Value vs Growth (RHS, %pt)
        225                                                                                                                                                         -2                                           view.
        200                                                                                                                                                         -4
                                                                                                                                                                                                                 i) In our view, financials offer the best mix of attractive
        175                                                                                                                                                         -6                                           valuations coupled with depressed ROE as illustrated in the
                                                                                                                                                                                                                 scatter chart in Exhibit 43. This implies that Financials are the
        150                                                                                                                                                         -8
                                                                                                                                                                                                                 one Value sector that offers the best chance of decent EPS
        125                                                                                                                                                         -10
                                                                                                                                                                                                                 growth over the next year or so as per our commentary above.

        100                                                                                                                                                         -12
                                                                                                                                                                                                                 ii) Financials is the most liquid way for investors to gain
                                                                                                                                                                                                                 exposure to any improvement in Europe’s macro outlook.
                                75                                                                                                                                  -14
                                                    75           80          85            90          95             00          05          10                                                                 There are few other ‘large and liquid’ ways to play a cyclical
Source: MSCI, Morgan Stanley Research                                                                                                                                                                            recovery in the region.
Exhibit 41
A better macro outlook is supportive to Value                                                                                                                                                                    iii) Financials offer the potential for relatively strong earnings
                                                                                                                                                                                                                 growth as profits recover from depressed levels. Exhibit 45
                                                    60                                                                                                 224                                                       shows that Financials’ earnings revisions have been superior
                                                                                                                                                              MSCI Europe Value vs Growth Relative Performance




                                                                                                                                                                                                                 to the market every week since the start of the year. Exhibit 46
                                                                                                             Global PMI
                                                    55
                                                                                                                                                       214                                                       also shows that the sector offers an increasingly interesting
 Global Revenue-Weighted PMI




                                                                                                                                                                                                                 dividend angle too.
                                                                                                                                                       204
                                                    50
                                                                                                                                                                                                                 iv) One consequence of current unconventional monetary
                                                                                                                                                       194
                                                                                                                                                                                                                 policy is that it is likely to keep yield curves relatively steep.
                                                    45
                                                                                                                                                       184
                                                                                                                                                                                                                 This should be a positive backdrop for sector profitability and
                                                                                                                                                                                                                 EPS growth (which will in time help the capital position too).
                                                    40
                                                                                                                                                       174

                                                                                      MSCI Europe Value vs Growth Relative Performance
                                                                                                                                                                                                                 Exhibit 43

                                                    35                                                                                                 164
                                                                                                                                                                                                                 Financials, Food Retail, and Materials offer the best
                                                     Jan-08   Aug-08   Mar-09     Oct-09   May-10   Dec-10   Jul-11    Feb-12    Sep-12   Apr-13                                                                 mix of low valuations and low ROE
Source: MSCI, ISM, Markit, HSBC, CFLP, Morgan Stanley Research                                                                                                                                                                                                                      2
                                                                                                                                                                                                                                                                         100       R = 0.3304                                                        Cap Goods
Exhibit 42                                                                                                                                                                                                                                                                                                                  Telcos
                                                                                                                                                                                                                                                                                                                                                                      Retailing
                                                                                                                                                                                                                                                                                                                                     Transport          Cons Serv
                                                                                                                                                                                                                  Latest Relative RoE %tile Relative to all Data since




                                                                                                                                                                                                                                                                                                                                                                        Cons Dur
Higher bund yields would suggest Value                                                                                                                                                                                                                                    90
                                                                                                                                                                                                                                                                                                            Health Care         Media               Autos        Food & Bev
outperformance too                                                                                                                                                                                                                                                        80
                                                                                                                                                                                                                                                                                                         Real Estate    Household Prod
                                                                                                                                                                                                                                                                                                                                                              Comm Serv
                                                                                                                                                                                                                                                                                                                               Pharma
                                                                                                                                                                                                                                                                          70                                                                                Semis
                                                    140                                                                                                 4.5
                                                                                                                                                                                                                                                                                                                 Software                                   HIGH VALUATIONS
                                                                                                                                                                                                                                                                          60                        Utilities
 MSCI Europe Value vs Growth Relative Performance




                                                                                                                                                                                                                                                                                    Insurance                                                               ON HIGH ROE
                                                                                  MSCI Europe Value vs Growth                                                                                                                                                                                        Energy
                                                                                                                                                                                                                                        1973




                                                    135                                                                                                 4.0                                                                                                               50

                                                    130                                                                                                                                                                                                                   40                                                            Materials
                                                                                                                                                        3.5
                                                                                                                                                              10Y Bund Yields (%)




                                                                                                                                                                                                                                                                          30                      Food Retail
                                                    125
                                                                                                                                                        3.0                                                                                                                         LOW VALUATIONS
                                                                                                                                                                                                                                                                          20
                                                                                                                                                                                                                                                                                    ON LOW ROE
                                                    120
                                                                                                                                                                                                                                                                          10                                                     Div Fin
                                                                                                                                                        2.5                                                                                                                                                          Tech Hardware
                                                                                                                                                                                                                                                                                                            Banks
                                                    115                                                                                                                                                                                                                    0
                                                                                                                                                                                                                                                                               0        10       20       30       40       50        60        70        80       90         100
                                                                             10Y Bund Yields (RHS)                                                      2.0                                                                                                                             Latest Relative Average Valuation Ex-PE %tile Relative to all Data since 1973
                                                    110

                                                                                                                                                                                                                 Source: MSCI, Morgan Stanley Research
                                                    105                                                                                                 1.5


                                                    100                                                                                                 1.0
                                                     Sep-08 Mar-09     Sep-09 Mar-10       Sep-10 Mar-11 Sep-11 Mar-12          Sep-12 Mar-13      Sep-13


Source: MSCI, Datastream, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                                                                                    15
                                                                                                                                                                                             MORGAN                                                           STANLEY                RESEARCH

                                                                                                                                                                                             September 4, 2013
                                                                                                                                                                                             European Strategy




Exhibit 44                                                                                                                                                                                   #3 Buying European exposure
Financials have the lowest PEG ratios
                                                                                                                                                                                             Over the last few months, investing in companies with above
                                                                                                                       Median PEG Current PEG as %
                                                              Trailing PE 12m EPS Growth                     PEG        since 1987     Median PEG                                            average exposure to Europe has become increasingly
Banks                                                                12.8            21.4                     0.6               1.1            -48
Insurance                                                            10.0             7.3                     1.4               1.7            -19                                           consensual and such stocks have outperformed significantly
Div Fin                                                              12.7            14.3                     0.9              1.1             -17
Transport                                                            17.1            21.6                     0.8               1.0            -17                                           as illustrated in Exhibit 47. While the more crowded nature of
Real Estate                                                          17.5             4.4                     4.0               3.8              6
Cap Goods                                                            15.9            14.6                     1.1              1.0               9
                                                                                                                                                                                             this trade suggests that future performance is likely to be more
Software
Food & Bev
                                                                     17.5
                                                                     17.8
                                                                                     10.6
                                                                                      8.1
                                                                                                              1.7
                                                                                                              2.2
                                                                                                                                1.3
                                                                                                                                1.8
                                                                                                                                                23
                                                                                                                                                24
                                                                                                                                                                                             muted, we believe that investor demand for European GDP
Cons Dur                                                             18.5            13.6                     1.4               1.1             26                                           plays will continue to be strong, reflecting better regional macro
Food Retail                                                          13.4             6.4                     2.1              1.6              34
Materials                                                            14.5            11.3                     1.3               1.0             35                                           data and only a modest positioning in this theme from global
Pharma                                                               14.9             5.5                     2.7              2.0              36
Retailing                                                            20.5            10.0                     2.0               1.5             41                                           clients. For example, US companies with relatively high
Media                                                                15.9             7.3                     2.2               1.5             43
Energy                                                                 9.8            4.1                     2.4              1.7              45                                           European exposure have recently started to outperform the
Comm Serv                                                            18.6             9.6                     1.9               1.3             50
Cons Serv                                                            18.3             8.0                     2.3               1.4             64
                                                                                                                                                                                             wider S&P.
Autos                                                                  8.4           -3.4                      na              0.7              na
Telecomms                                                            11.4            -1.8                      na               1.7             na
Utilities                                                            10.8            -4.5                      na               1.9             na                                           As illustrated in Exhibits 48-50, our basket of Euro-zone
Source: MSCI, IBES, Morgan Stanley Research                                                                                                                                                  exposed stocks has seen years of underperformance versus
Exhibit 45                                                                                                                                                                                   our basket of US and EM exposed stocks; relative valuations of
Financials have enjoyed consistently higher                                                                                                                                                  the former basket are also undemanding and relative earnings
earnings revisions than the market all year                                                                                                                                                  revisions have turned strongly positive.

                                       20                                                                                                        -5


                                       15
                                                                                                                                                       % Premium vs MSCI Europe On N12M PE




                                                                                                                                                 -10
                                                                                                                                                                                             Exhibit 47
 FY1 ERR relative to MSCI Europe (%)




                                       10                                                                                                                                                    Our EU basket has outperformed recently as
                                                                                                                                                 -15
                                                                                                                                                                                             Europe’s macro data turned up
                                        5
                                                                                                                                                 -20                                                                                            110                                                                                   200
                                                                                                                                                                                                                                                                                      Relative Performance of Eurozone Basket
                                        0
                                                                                                                                                                                              Relative Performance of Eurozone Basket vs MSCI




                                                                                                                                                                                                                                                                                      Eurozone Economic Surprise Index (RHS)
                                                                                                                                                                                                                                                105                                                                                   150
                                                                                                                                                 -25




                                                                                                                                                                                                                                                                                                                                             Eurozone Economic Surprise Index
                                        -5
                                                                                                                                                                                                                                                100                                                                                   100
                                                                                                                                                                                                             Europe ex-Financials




                                                                                                                                                 -30
                                       -10                                                                                                                                                                                                       95                                                                                   50

                                                         Financials Relative FY1 ERR                 Financials Relative N12M PE (RHS)
                                       -15                                                                                                       -35                                                                                             90                                                                                   0
                                         Jan-10           Sep-10              May-11              Jan-12            Sep-12        May-13
                                                                                                                                                                                                                                                 85                                                                                   -50
Source: MSCI, IBES, Morgan Stanley Research
Exhibit 46                                                                                                                                                                                                                                       80                                                                                   -100

Financials offer a good dividend proposition                                                                                                                                                                                                     75                                                                                   -150

                                       80
                                                                                                                                                                                                                                                 70                                                                                   -200
                                                                                                                                                                                                                                                  Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13
                                                                                                                                         Utilities
                                       70
                                                                                                                                 Telecoms                                                    Source: MSCI, Citigroup, Morgan Stanley Research
 Consensus 2013 Payout Ratio (%)




                                                                                Retailing
                                       60                                                           MSCI Europe
                                                                    Food/Bev/Tob
                                                                                       Media
                                                                                                              Banks
                                       50
                                                                                                           Insurance
                                                                                                                        Energy
                                                                                       Material
                                       40


                                                                                   Autos
                                       30
                                                                   Div Fins


                                       20
                                             1.0   1.5       2.0        2.5      3.0     3.5      4.0     4.5             5.0    5.5       6.0        6.5
                                                                               Consensus 2013 Dividend Yield (%)


Source: MSCI, IBES, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                                                                                16
                                                                                                                                                                                    MORGAN        STANLEY   RESEARCH

                                                                                                                                                                                    September 4, 2013
                                                                                                                                                                                    European Strategy




Exhibit 48
Our EU basket is just beginning to claw back years
of underperformance versus our US and EM baskets
                                                                            135
                                                                                                                                      Eurozone Basket vs US Basket
 Rel Perf of Eurozone Basket (MSSTREEU) vs US Basket




                                                                            125                                                       Eurozone Basket vs EM Basket
       (MSSTREUS) and EM Basket (MSSTREEM)




                                                                            115


                                                                            105


                                                                             95


                                                                             85


                                                                             75


                                                                             65


                                                                             55


                                                                             45
                                                                              Jan-08    Oct-08      Jul-09       Apr-10      Jan-11       Oct-11        Jul-12      Apr-13


Source: MSCI, Morgan Stanley Research

Exhibit 49
Valuations for our EU basket do not appear to be
overly demanding…
           Median Basket Valuations - % Premium / Discount to Median




                                                                              70
                                                                                                                                                            N12M PE
                                                                              60                                                                            Trailing PE
                                                                                                                                                            Trailing PBV
                                                                              50

                                                                              40
                              Market Valuations




                                                                              30

                                                                              20

                                                                              10

                                                                                  0

                                                                             -10

                                                                             -20

                                                                             -30
                                                                               Jan-08   Sep-08     May-09      Jan-10     Sep-10   May-11      Jan-12      Sep-12     May-13


Source: MSCI, IBES, Morgan Stanley Research
Exhibit 50
… especially given the big improvement occurring
in relative earnings revisions

                                                                            10
                                                                                                                                                            FY1
                      Relative Earnings Revisions Ratio of Basket, 3mma %




                                                                             8                                                                              FY2

                                                                             6

                                                                             4

                                                                             2

                                                                             0

                                                                             -2

                                                                             -4

                                                                             -6

                                                                             -8

                                                                            -10

                                                                            -12
                                                                              Feb-08      Jan-09            Dec-09        Nov-10         Oct-11           Sep-12           Aug-13


Source: MSCI, IBES, Morgan Stanley Research




                                                                                                                                                                                                                       17
                                                                                                        MORGAN               STANLEY              RESEARCH

                                                                                                        September 4, 2013
                                                                                                        European Strategy




#4 Dividend growth and yield                                                                            dividends will remain a key focus for many investors. In
Compared to the Spring Update we wrote back in March, we                                                particular, stocks offering a reasonable dividend yield coupled
believe the most important change in the macro landscape is a                                           with decent dividend growth should be in demand.
likely structural inflection point in US (and therefore global)
monetary policy. With a bias now toward higher bond yields,                                             In this regard, Exhibit 51 provides a stock screen that
bond proxy stocks or those companies offering a high dividend                                           equal-weight ranks European companies based on their
yield with little or no growth are unlikely to be in such demand                                        dividend yield, dividend growth and balance sheet. The stocks
from investors. Consequently, we would no longer recommend                                              on this list are those that score best when judged across all
our ‘High & Secure Dividend Yield’ strategy that we have                                                three metrics.
written regularly about over the last few years.
                                                                                                        Overweight rated names in the top 50 of the list include:
However, given the demographic outlook and a lack of good                                               Telenor, Ericsson, Petrofac, Ziggo, Imperial Tobacco,
income opportunities in other asset markets we believe that                                             Deutsche Post, Sanofi, Seadrill, Roche and BHP Billiton.




Exhibit 51
Stocks offering a reasonable DY (>3%), 5%+ DPS growth and a solid balance sheet
                                                                                                             2013e      DPS CAGR      2013e Net   Rel. Perf. to MSCI
                                                                                                            Dividend    (2012-2015,    debt to       Europe (%)          EPS Growth (%)
  Rank   Name                          Sector                       Country            Price      mn)       Yield (%)       %)         Equity      6m           12m     2013E      2014E      MS Rating
    1    NOKIAN RENKAAT                Consumer Discretionary       Finland              €35.89     6,204       4.7         14.9         -0.1       -2.3         -4.5       3.2      12.3          -
    2    BERKELEY GRP HLDGS UNIT       Consumer Discretionary       United Kingdom       £21.82     4,330       4.3         13.3         -0.1       10.0         28.3      20.4      10.4          -
    3    AMEC                          Energy                       United Kingdom       £10.49     4,810       3.7         10.3         -0.1       -1.9        -17.0       5.6      11.2    Underweight / I
    4    HUGO BOSS                     Consumer Discretionary       Germany              €94.00     8,558       3.7         12.6          0.1       -1.4          3.1      10.9      15.0       NAV / I
    5    TELENOR                       Telecommunication Services   Norway           NOK129.70     31,712       5.3         12.3          0.5        1.3          9.7      30.2      10.9    Overweight / I
    6    BP                            Energy                       United Kingdom        £4.46   130,903       5.3          8.0          0.2       -6.6        -16.5     -12.8      16.9    Underweight / I
    7    ERICSSON (LM) B               Information Technology       Sweden            SEK78.60     38,820       3.8          7.7         -0.3       -4.4          4.3      47.6      29.3    Overweight / I
    8    PETROFAC                      Energy                       United Kingdom       £14.10     7,457       3.4         12.7          0.1      -25.8        -28.8       7.6      17.4    Overweight / I
    9    TUI TRAVEL                    Consumer Discretionary       United Kingdom        £3.48     5,993       3.6          9.9          0.0        5.4         45.4      13.8       9.1   Equal-Weight / I
   10    KUEHNE & NAGEL INT'L          Industrials                  Switzerland       SFr117.00    14,886       3.3         10.3         -0.4        2.1         -8.4      11.2      12.0    Underweight / I
   11    TRANSOCEAN                    Energy                       Switzerland        SFr42.74    16,232       3.6         42.8          0.5      -17.0        -21.8       4.0      36.8          -
   12    EMS-CHEMIE HOLDING            Materials                    Switzerland       SFr302.75     7,454       3.3         11.5         -0.3       13.5         46.9      10.7       1.4          -
   13    MAN STAMM                     Industrials                  Germany              €86.91    16,781       3.5         45.3          0.4       -7.3         -2.1    -100.0         -   Equal-Weight / I
   14    BMW STAMM                     Consumer Discretionary       Germany              €72.76    60,551       3.5          7.8         -0.4        3.7          4.6       0.9       3.6   Equal-Weight / I
   15    ZIGGO                         Telecommunication Services   Netherlands          €30.91     7,914       6.3         14.2          2.2       11.1          5.2      54.7       0.3    Overweight / I
   16    AHOLD (KON.)                  Consumer Staples             Netherlands          €12.46    16,868       3.6          7.7         -0.1       10.8          5.2      -8.0      14.9   Equal-Weight / I
   17    IMPERIAL TOBACCO GROUP        Consumer Staples             United Kingdom       £21.33    32,166       5.4         10.0          1.5      -13.9        -24.1       4.6       6.7    Overweight / A
   18    AKER SOLUTIONS                Energy                       Norway            NOK92.00      4,182       3.8         11.2          0.6      -22.0        -23.7     -14.2      51.6          -
   19    SES A-FDR                     Consumer Discretionary       France               €22.25     9,898       4.9         10.0          1.5      -13.3        -12.4      -9.9       9.6   Underweight / A
   20    GIVAUDAN                      Materials                    Switzerland      SFr1270.00    12,383       3.3         12.3          0.2       11.0         22.8       8.7      11.3   Equal-Weight / I
   21    RIO TINTO PLC                 Materials                    United Kingdom       £30.35    64,046       3.8          9.5          0.6      -16.9        -12.8       1.2      18.5   Equal-Weight / I
   22    DEUTSCHE POST                 Industrials                  Germany              €22.64    34,856       3.4          8.8          0.2       21.3         20.6      10.9       6.6    Overweight / I
   23    MILLICOM INT'L CELLULAR       Telecommunication Services   Sweden           SEK540.50      8,246       3.6         14.0          1.0       -0.7        -24.0      -7.6       9.1   Equal-Weight / I
   24    KONE B                        Industrials                  Finland              €63.30    18,211       3.0          9.3         -0.5       -6.0          7.5      14.6      10.4          -
   25    MORRISON WM SUPERMARKETS      Consumer Staples             United Kingdom        £2.91    10,539       4.5          6.8          0.5        3.7        -12.4      -4.0       2.7    Underweight / I
   26    SANOFI                        Health Care                  France               €74.40   127,193       3.7          6.5          0.1       -1.4         -1.5     -14.0      13.3    Overweight / A
   27    BRITISH AMERICAN TOBACCO      Consumer Staples             United Kingdom       £32.75    96,400       4.4          8.4          1.2       -8.5        -13.0       7.1       8.1   Equal-Weight / A
   28    PIRELLI & CO ORD              Consumer Discretionary       Italy                 €8.93     5,705       3.4         12.0          0.5       10.5         -7.9      -0.6      24.1          -
   29    COBHAM                        Industrials                  United Kingdom        £2.84     4,779       3.3         10.0          0.3       19.3         11.6      -4.7       3.2    Underweight / I
   30    ELECTROLUX B                  Consumer Discretionary       Sweden           SEK179.50      8,200       3.7          7.2          0.4        5.0          1.0      -3.2      35.2          -
   31    PEARSON                       Consumer Discretionary       United Kingdom       £12.99    16,190       3.6          6.4          0.2        3.4         -6.9      -9.3      16.9   Underweight / A
   32    SEADRILL LTD                  Energy                       Norway           NOK287.30     21,784       8.1          7.7          2.0       21.2         -6.9      28.6      32.4    Overweight / I
   33    ROCHE HOLDING GENUSS          Health Care                  Switzerland       SFr236.50   214,262       3.4          8.7          0.3        7.8         18.8      10.5       7.2    Overweight / A
   34    BRITISH SKY BROADCASTING      Consumer Discretionary       United Kingdom        £8.53    20,798       3.6         10.0          1.4       -5.1         -6.6      17.3      -0.4   Equal-Weight / A
   35    SANDVIK                       Industrials                  Sweden            SEK90.40     16,828       4.2          6.7          0.5      -21.7        -19.6     -15.2      13.1   Underweight / C
   36    ATLAS COPCO A                 Industrials                  Sweden           SEK180.90     32,357       3.3          6.9          0.1       -8.7          0.4      -8.4       5.3   Equal-Weight / C
   37    GEBERIT                       Industrials                  Switzerland       SFr230.40     9,159       3.0          7.5         -0.3       -1.2          0.4       9.5       5.4    Underweight / I
   38    ENAGAS                        Utilities                    Spain                €17.46     5,409       7.0          6.7          1.8       -6.9          2.7       6.3       2.8   Equal-Weight / I
   39    BOSKALIS WESTMINSTER CT       Industrials                  Netherlands          €30.35     4,750       4.1          6.3          0.5      -13.8         -4.5       8.1       5.1          -
   40    MICHELIN                      Consumer Discretionary       France               €73.71    17,871       3.2          7.2          0.1        8.6          9.6      -7.7      15.5          -
   41    SKF B                         Industrials                  Sweden           SEK180.00     12,097       3.2          8.4          0.3        5.0          7.3      -3.7      24.3   Equal-Weight / C
   42    VOLVO B                       Industrials                  Sweden            SEK96.40     30,743       3.1         10.1          0.4       -6.7         -3.5     -24.9      90.2   Equal-Weight / I
   43    BHP BILLITON PLC              Materials                    United Kingdom       £19.21    61,734       3.9          7.1          1.0      -13.5        -16.3     -24.3      12.9    Overweight / I
   44    UNILEVER NV CERT              Consumer Staples             Netherlands          €28.90    64,474       3.6          7.9          0.9       -7.3         -9.8       1.8       8.8   Equal-Weight / I
   45    SCANIA B                      Industrials                  Sweden           SEK132.80     15,732       3.4          5.0         -0.1       -5.1          1.2      -3.5      17.2       NAV / I
   46    WARTSILA B                    Industrials                  Finland              €36.10     9,190       3.0          9.1          0.2       -4.2         17.2       2.1      17.1          -
   47    INFORMA GROUP                 Consumer Discretionary       United Kingdom        £5.14     4,774       3.8          6.2          0.5       -2.5          8.9       0.8       6.9   Equal-Weight / A
   48    REXAM                         Materials                    United Kingdom        £4.97     6,012       3.4          8.8          0.6       -6.1         -0.7       2.7      10.0          -
   49    ABB LTD                       Industrials                  Switzerland        SFr20.13    49,303       3.4          5.6          0.1       -8.0          4.3      18.6      16.3   Underweight / C
   50    CENTRICA                      Utilities                    United Kingdom        £3.89    30,909       4.5          5.7          0.8        5.1          1.5       4.2       5.1   Equal-Weight / I

For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure Website at
www.morganstanley.com/researchdisclosures.For important disclosures regarding non-covered companies that are the subject of this screen, please refer to the Disclosure Section, located at the end
of this report. A=Attractive, I=In-line, C=Cautious. Prices are updated as of 02 September 2013.
Source: MSCI, Factset estimates, Morgan Stanley Research.




                                                                                                                                                                                                               18
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                                                                                                               September 4, 2013
                                                                                                               European Strategy




#5 Cyclicals vs Defensives                                                                                     Exhibit 53

While our medium-term outlook that envisages higher equity                                                     Our MTI > 0SD has been a good signal to sell
prices and a moderate recovery in GDP and EPS should                                                           cyclicals and buy defensives
generally favour cyclicals over defensives, we are more                                                                                                                1.0                                                                                                    100
circumspect in the shorter term and advocate a relatively                                                                                                                           Sell above +0.5




                                                                                                                                                                                                                                                                                   Cyclicals vs Defensives - Relative Total Return
                                                                                                                                                                       0.5                                                                                                    95
neutral position between the two groups just now.




                                                                                                                Combined Market Timing Indicator (CMTI)
                                                                                                                                                                       0.0
                                                                                                                                                                                                                                                                              90

Reasons for investors to take a more cautious view on cyclicals                                                                                               -0.5
                                                                                                                                                                                                                                                                              85




                                                                                                                                                                                                                                                                                                    Performance
in the short term include:                                                                                                                                    -1.0
                                                                                                                                                                                                                                                                              80
                                                                                                                                                              -1.5                                                                                       Buy below -0.5
i) As illustrated in Exhibit 53, the relative performance of                                                                                                                                                                                                                  75
                                                                                                                                                              -2.0
cyclicals versus defensives tends to closely track our MTI
                                                                                                                                                                                                                                                                              70
which has now moved above 0SD and is approaching levels it                                                                                                    -2.5

has tended to peak out at in this cycle.                                                                                                                      -3.0                                    Combined Market Timing Indicator                                        65
                                                                                                                                                                                                      Cyclicals vs Defensives - Relative Total Return Performance (RHS)
                                                                                                                                                              -3.5                                                                                                            60
ii) As illustrated in Exhibit 54, the breadth of stock                                                                                                          Aug-08                        Aug-09              Aug-10           Aug-11             Aug-12            Aug-13

outperformance across cyclical sectors has been relatively                                                     Source: MSCI, Morgan Stanley Research
high in recent months and approaching levels where the
                                                                                                               Exhibit 54
group’s relative performance usually starts to suffer.                                                         Breadth of cyclical outperformance is above
                                                                                                               average
iii) Most cyclical sectors are not particularly cheap relative to
history. Perhaps the best way to show this is simply the table in                                                                                                         90             % of Cyclicals & Materials Stocks Outperforming the Market over the L3M             135
                                                                                                                    % of Cyclicals & Materials Stocks Outperforming the




Exhibit 52 that shows long-term relative valuation percentiles.                                                                                                                          MSCI Europe Cyclicals & Materials - Relative Total Return Performance vs
                                                                                                                                                                                                                                                                             130




                                                                                                                                                                                                                                                                                   MSCI Europe Cyclicals & Materials - Relative
                                                                                                                                                                          80             Market
Sectors at the bottom of the table are expensive versus their
                                                                                                                                                                                                                                                                             125
history – only one of the 11 sectors at the bottom of this table is                                                                                                       70




                                                                                                                                                                                                                                                                                            Performance vs Market
                                                                                                                                    Market over the L3M




not a cyclical (Food & Beverages). Using this same                                                                                                                                                                                                                           120
                                                                                                                                                                          60
methodology, Exhibit 55 plots the relative valuation percentile                                                                                                                                                                                                              115
over time for the median cyclical sector and it shows the current                                                                                                         50
                                                                                                                                                                                                                                                                             110
valuation is at its highest level since 1987.
                                                                                                                                                                          40
                                                                                                                                                                                                                                                                             105
Exhibit 52
                                                                                                                                                                          30
Relative valuation percentiles for European sectors                                                                                                                                                                                                                          100


                                                                                                                                                                          20                                                                                                 95
                                                Latest Relative Multiples (%tile, Relative to all Data since
                                                                                                                                                                               03       04      05         06      07      08      09       10     11      12      13
                                                                           1973)
Industry Group                                    P/D          P/S          P/B          P/E       Avg ex PE
Insurance                                          18            -           13           7            15      Source: MSCI, Morgan Stanley Research
Food & Staples Retailing                           35            5           20          38            20
Utilities                                          29            1           33          41            21      Exhibit 55
Energy                                             48            4           21          18            24
Banks                                              49            -           7           92            28      The median cyclical sector is at its highest
Technology Hardware & Equipment                    84           21           12           -            39
Real Estate                                        17            -           62          26            39      percentile relative valuation since 1987
Software & Services                                31           47           44          41            41
Telecommunication Services                         46           3            77          25            42
Household & Personal Products                      13           75           44          52            44                                                              100
Health Care Equipment & Services                   31           35           73          65            46
Pharmaceuticals Biotechnology & Life Sciences       9           61           74          36            48                                                                 90
Diversified Financials                             98            -           10          93            54
                                                                                                                                                                                                                                                                     Cyclicals
Materials                                          80           13           72          92            55                                                                 80
                                                                                                                                      Relative Valuation Percentiles




Media                                              24           69           83          53            58
Transportation                                     86           25           94          28            68                                                                 70
Automobiles & Components                           55           82           70          18            69
Semiconductors & Semiconductor Equipment           49          100           89          49            79
                                                                                                                                                                          60
Capital Goods                                      61           84          100          52            82
Commercial & Professional Services                 75           77           96          99            83
Food Beverage & Tobacco                            70           96           93          83            86                                                                 50
Consumer Services                                 100           66           99          39            88
Retailing                                          66          100          100          79            89                                                                 40
Consumer Durables & Apparel                        89          100           91          76            93
                                                                                                                                                                          30
MSCI Europe                                        56          66           44          63           55
                                                                                                                                                                                                                                                                        Defensives
                                                                                                                                                                          20
Source: MSCI, Morgan Stanley Research
                                                                                                                                                                          10
                                                                                                                                                                          Dec-82          Dec-86         Dec-90      Dec-94      Dec-98      Dec-02      Dec-06      Dec-10


                                                                                                               Source: MSCI, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                                     19
                                                                                MORGAN                                              STANLEY                   RESEARCH

                                                                                September 4, 2013
                                                                                European Strategy




iv) In addition, Exhibit 56 shows that the proportion of cyclical               Exhibit 57

stocks in the ‘multiple appearances’ table of our Sellers                       Absolute and relative normalised PE ratios for
Compendium product is at the high end of the historical range –                 European sectors
that is, our quantitative screen of potential sell ideas has a high                                                             Normalised PE - Absolute                       Normalised PE - Relative*
                                                                                                                               Current LT Median      % diff                Current    LT Median       ppt diff
weighting of cyclical names.                                                    Retailing                                           28          20        36                    126             24         102
                                                                                Cons Serv                                           21          16        28                     71              0          71
                                                                                Cons Dur                                            21          17        19                     70              1          69
                                                                                Cap Goods                                           19          18         8                     55              4          51
Cyclicals trade at close to record highs on relative                            Media                                               25          23         6                    101             52          49
                                                                                Comm Serv                                           21          21         0                     67             28          40
normalized PE but average absolute normalized PEs                               Autos                                               13          13         6                      8            -26          34
One of the reasons for the relatively high valuations of cyclicals              Food & Bev
                                                                                Software
                                                                                                                                    17
                                                                                                                                    27
                                                                                                                                                18
                                                                                                                                                28
                                                                                                                                                          -2
                                                                                                                                                          -4
                                                                                                                                                                                 42
                                                                                                                                                                                117
                                                                                                                                                                                                15
                                                                                                                                                                                                95
                                                                                                                                                                                                            27
                                                                                                                                                                                                            22
is likely to be concerns over a perceived lack of interesting                   Transport                                           17          19       -12                     37             17          20
                                                                                Pharma                                              18          21       -13                     45             33          13
investment opportunities in other areas of the market that                      Real Estate                                         17          21       -20                     35             28           7
                                                                                Materials                                           12          15       -25                     -6             -8           3
depresses valuations elsewhere. To illustrate, Exhibit 57                       Food Retail                                         13          17       -23                      7              7           0
                                                                                Div Fin                                             10          14       -30                    -18            -18           0
details absolute and normalized PE ratios today and relative to                 Health Care                                         20          25       -18                     64             65          -1
                                                                                Household Prod                                      18          24       -24                     47             55          -8
their long-term median reading (back to 1985). The relative                     Banks                                                7          11       -36                    -41            -31         -10
                                                                                Telecomms                                           13          17       -28                      3             15         -12
normalized PE for the Cyclicals group is currently +57%, 44                     Utilities                                            8          16       -48                    -33            -11         -22
percentage points above the long-term median of 12%. While                      Insurance
                                                                                Energy
                                                                                                                                    11
                                                                                                                                     7
                                                                                                                                                22
                                                                                                                                                14
                                                                                                                                                         -51
                                                                                                                                                         -54
                                                                                                                                                                                -13
                                                                                                                                                                                -47
                                                                                                                                                                                                18
                                                                                                                                                                                               -12
                                                                                                                                                                                                           -31
                                                                                                                                                                                                           -35
this is close to a record high, in absolute terms the current
                                                                                Cyclicals                                            19             18            7              57                 12            44
normalized PE is 19 versus a long-term median of 18. In                         Defensives                                           16             18          -13              28                 13            14
                                                                                Commodities                                           8             15          -43             -33                -12           -21
summary, cyclicals are not unduly expensive in absolute terms,                  Ex-Fins                                              14             17          -17              13                  4             9
                                                                                Financials                                            9             15          -41             -29                 -9           -20
however their valuation gap to the more depressed areas of the                  Europe                                               12             16          -24

market (such as financials, energy, telecoms and utilities) is                  Source: MSCI, Morgan Stanley Research
very wide versus history.                                                       Exhibit 58
                                                                                Cyclicals’ normalised PE is high in relative terms
Within defensives we prefer Pharmaceuticals and Food                            but not in absolute terms
Retailing
                                                                                                               60                                                                                               120
While the above analysis cautions against being too optimistic                                                                                                             Normalised PE - relative

                                                                                                                                     Normalised PE - absolute
on cyclicals at this time, neither is it particularly positive for                                             50                                                                                               110




                                                                                                                                                                                                                      Cyclicals Relative Price Performance
defensives – for example, the groups’ relative normalized PE is                                                40                                                                                               100
                                                                                 Normalised PE for Cyclicals




also above its long-term median by 14 percentage points. The
                                                                                                               30                                                                                               90
breadth of outperformance within the defensive sectors is also
                                                                                                               20                                                                                               80
around average as shown in Exhibit 60. Within the group we
continue to prefer Pharmaceuticals and Food Retailing as we                                                    10                                                                                               70

feel their valuations are less demanding than Consumer                                                          0                                                                                               60

Staples, but they offer some growth unlike the cheaper sectors
                                                                                                               -10                                                                    Cyclicals relative        50
such as Utilities and Telecoms. Pharmaceuticals should also                                                                                                                           performance

benefit from our FX strategists’ call for a stronger USD.                                                      -20
                                                                                                                     84   86   88    90   92   94        96    98     00   02   04     06    08     10     12
                                                                                                                                                                                                                40




Exhibit 56                                                                      Source: MSCI, Morgan Stanley Research

Cyclical stocks account for a high proportion of
stocks in our ‘Sellers Compendium’ product
90%
                       Financials       Energy
80%                    Cyclicals        Defensives


70%


60%


50%


40%


30%


20%


10%


 0%
   Apr-07     Apr-08      Apr-09    Apr-10           Apr-11   Apr-12   Apr-13


Source: MSCI, Morgan Stanley Research




                                                                                                                                                                                                                                                             20
                                                                                                                                                                                              MORGAN                                                               STANLEY                  RESEARCH

                                                                                                                                                                                              September 4, 2013
                                                                                                                                                                                              European Strategy




Exhibit 59                                                                                                                                                                                    Exhibit 60
Defensives’ normalised PE is above average in                                                                                                                                                 Breadth of defensive outperformance is around the
relative terms but below in absolute terms                                                                                                                                                    historic average
                               70                                                                                                220                                                                                                             90                                                                                          130
                                                                                                                                                                                                                                                               % of Defensives Stocks Outperforming the Market over the L3M
                                                                                                                                                                                                                                                               MSCI Europe Defensives - Relative Total Return Performance vs Market




                                                                                                                                                                                               % of Defensives Stocks Outperforming the Market
                                                                                                                                                                                                                                                                                                                                             125




                                                                                                                                                                                                                                                                                                                                                   MSCI Europe Defensives - Relative Total Return
                               60                                                                                                                                                                                                                80
                                                                                                                                 200




                                                                                                                                       Defensives' Relative Price Performance
                                                       Normalised PE - absolute                                                                                                                                                                                                                                                              120
                               50                                                                                                                                                                                                                70
 Normalised Pefor Defensives




                                                                                                                                 180
                                                                                                                                                                                                                                                                                                                                             115




                                                                                                                                                                                                                                                                                                                                                             Performance vs Market
                               40                                                                                                                                                                                                                60
                                                                                                                                                                                                                                                                                                                                             110




                                                                                                                                                                                                                over the L3M
                               30                                                                                                160
                                                                                                                                                                                                                                                 50
                                                                                                                                                                                                                                                                                                                                             105
                               20                                                                                                140                                                                                                             40
                                                                                                                                                                                                                                                                                                                                             100
                               10                                                                                                                                                                                                                30
                                                                                                                                 120                                                                                                                                                                                                         95
                                0
                                                                                                                                                                                                                                                 20
                                                                                                                                                                                                                                                                                                                                             90
                                                                                                                                 100
                               -10               Cyclicals relative                            Normalised PE - relative                                                                                                                          10                                                                                          85
                                                 performance
                               -20                                                                                               80
                                                                                                                                                                                                                                                  0                                                                                          80
                                     84     86    88    90     92     94   96     98    00    02    04    06    08    10    12
                                                                                                                                                                                                                                                      03      04     05        06    07     08      09      10     11         12      13


Source: MSCI, Morgan Stanley Research                                                                                                                                                         Source: MSCI, Morgan Stanley Research




Exhibit 61
Stocks offering 6% EPS CAGR with 2013 PE < 13 and 2013 DY > 3%
                                                                                                                                                                                                                                                                                                             2012-2015E
                                                                                                                                                                                     MS                                                                             Market          2013E        2013E          EPS            Relative Performance (%)
         Rank                             Company Name                                 GICS industry group           Country                                                        Rating                                                            Price        Cap ($mn)         PE          DY (%)       CAGR (%)            -3M           -6M
                         1                Mapfre SA                                    Insurance                     Spain                                                       Overweight / I                                                       € 2.61          10,710          9.0            5.4          15.2              -3.0             1.9
                         2                AXA                                          Insurance                     France                                                      Overweight / I                                                     € 16.55           52,810          8.7            5.1          13.9              11.6            21.2
                         3                bpost SA                                     Transportation                Belgium                                                    Equal-Weight / I                                                    € 14.72            3,927         11.4            7.5          48.5                 -               -
                         4                Vedanta                                      Materials                     United Kingdom                                             Equal-Weight / I                                                    £ 12.09            5,005         10.2            5.7          12.9              -2.9             0.2
                         5                Bouygues                                     Capital Goods                 France                                                     Equal-Weight / I                                                    € 25.33           10,785         11.2            6.5          14.5              27.2            14.1
                         6                Investec Plc                                 Diversified Financials        United Kingdom                                              Overweight / I                                                      £ 4.12            3,899         10.8            4.8          17.4             -13.4           -16.2
                         7                AEGON                                        Insurance                     Netherlands                                                 Overweight / I                                                      € 5.42           15,271          8.0            4.2          11.7              10.8            15.2
                         8                Old Mutual                                   Insurance                     United Kingdom                                             Equal-Weight / I                                                     £ 1.83           13,922          9.3            4.5          12.8             -12.4           -11.9
                         9                Generali                                     Insurance                     Italy                                                       Underweight / I                                                    € 14.76           30,656          8.6            3.3         207.4               4.6            15.8
                         10               RSA                                          Insurance                     United Kingdom                                              Overweight / I                                                      £ 1.21            6,856         10.9            5.1          11.6               9.0            -2.6
                         11               Alstom                                       Capital Goods                 France                                                     Equal-Weight / C                                                    € 26.62           10,955          8.6            3.4          14.7              -5.7           -23.3
                         13               Renault                                      Automobiles & Components      France                                                      Overweight / I                                                     € 55.04           21,714          6.6            3.4          12.3              -7.2            10.3
                         14               Natixis                                      Banks                         France                                                      Overweight / I                                                       € 3.26          13,467         11.0            4.9          10.9              11.1            19.4
                         15               Imperial Tobacco                             Food Beverage & Tobacco       United Kingdom                                              Overweight / A                                                     £ 21.40           32,236         10.1            5.5           7.3              -8.2           -12.7
                         16               Aberdeen Asset Management                    Diversified Financials        United Kingdom                                             Equal-Weight / I                                                     £ 3.48            6,487         11.4            4.3          19.8             -26.7           -21.1
                         17               Allianz                                      Insurance                     Germany                                                    Equal-Weight / I                                                   € 110.35           67,122          8.2            4.9           6.2              -5.2             2.7
                         18               Rio Tinto Plc                                Materials                     United Kingdom                                             Equal-Weight / I                                                    £ 29.75           65,290          9.3            4.1          10.6               7.1           -18.1
                         19               Pirelli & C. SpA                             Automobiles & Components      Italy                                                             -                                                             € 8.99            5,702         10.1            3.8          12.0               8.4            -1.6
                         20               HSBC Holdings                                Banks                         United Kingdom                                             Equal-Weight / I                                                     £ 6.78          196,452         11.2            4.8           9.1              -5.4            -9.6
                         21               Aviva                                        Insurance                     United Kingdom                                              Overweight / I                                                      £ 3.94           18,057          9.8            3.7           9.3              22.8             7.7
                         22               Castellum                                    Real Estate                   Sweden                                                     Equal-Weight / A                                                  SEK 90.70            2,397         11.0            4.6           7.8              -8.9            -9.1
                         23               Transocean                                   Energy                        Switzerland                                                Equal-Weight / I                                                    $ 45.68           16,464         11.8            3.7          19.4              -9.5           -14.9
                         24               UPM-Kymmene Oyj                              Materials                     Finland                                                    Equal-Weight / I                                                      € 9.28           6,539         11.3            7.0           6.4              14.7             1.0
                         25               Snam                                         Utilities                     Italy                                                       Overweight / I                                                       € 3.51          15,817         12.9            7.1           8.2              -1.2            -5.9
                         26               Michelin                                     Automobiles & Components      France                                                            -                                                            € 72.24           18,039          8.3            3.5           7.7              10.9             2.9
                         27               Legal and General                            Insurance                     United Kingdom                                             Equal-Weight / I                                                     £ 1.87           17,223         12.6            4.9           8.5               6.6            14.1
                         29               Standard Chartered Bank                      Banks                         United Kingdom                                             Equal-Weight / I                                                    £ 14.35           54,032         10.0            4.1           6.8              -4.0           -22.1
                         30               TGS-NOPEC Geophysical Company ASA            Energy                        Norway                                                      Underweight / I                                                 NOK 184.30            3,151         11.4            4.5           7.8             -10.4           -17.3
                         31               Telenor                                      Telecommunication Services    Norway                                                      Overweight / I                                                  NOK 126.70           31,737         12.7            5.5           6.9               2.8            -0.1
                         32               AMEC                                         Energy                        United Kingdom                                              Underweight / I                                                    £ 10.62            4,907         12.5            3.5          12.4               3.9            -0.9
                         33               TUI Travel                                   Consumer Services             United Kingdom                                             Equal-Weight / I                                                     £ 3.41            5,928         11.5            3.8          10.0              -4.2             4.8
                         34               Storebrand                                   Insurance                     Norway                                                      Overweight / I                                                   NOK 34.57            2,569          8.6            3.5           6.1              32.7            30.4
                         35               Millicom                                     Telecommunication Services    Luxembourg                                                 Equal-Weight / I                                                 SEK 528.00            8,250         13.0            4.2          11.6              -3.4             1.4
                         36               SEB                                          Banks                         Sweden                                                     Equal-Weight / I                                                  SEK 68.05           22,687         11.2            4.0           7.1              -0.7            -1.5
                         37               Ashmore Group PLC                            Diversified Financials        United Kingdom                                             Equal-Weight / I                                                     £ 3.37            3,701         12.8            4.5           7.4             -18.9            -8.4
                         38               Petrofac                                     Energy                        United Kingdom                                              Overweight / I                                                     £ 13.75            7,389         11.6            3.0          10.5               2.6            -7.8
                         39               Sainsbury                                    Food & Staples Retailing      United Kingdom                                              Overweight / I                                                       £ 3.91          11,553         12.1            4.4           6.6               5.8            10.3
                         40               Tate & Lyle Plc                              Food Beverage & Tobacco       United Kingdom                                              Overweight / I                                                      £ 7.97            5,775         12.8            3.5           9.6              -5.6            -4.4

For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure Website at
www.morganstanley.com/researchdisclosures.For important disclosures regarding non-covered companies that are the subject of this screen, please refer to the Disclosure Section, located at the end
of this report. A=Attractive, I=In-line, C=Cautious. Prices are updated as of 29 August 2013.
Source: MSCI, Factset estimates, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                                                                                                    21
                                                                                                                                        MORGAN                   STANLEY                    RESEARCH

                                                                                                                                        September 4, 2013
                                                                                                                                        European Strategy




Exhibit 62
This screen ranks stocks on a combination of: 1) low normalized PE; 2) low ROE versus history; 3) high EPS
CAGR; 4) Low net debt to equity
                                                                                                                                                                                                                                                   Relative
                                                                                                                                                     12m Forward ROE (%)          P/E     P/BV    DY (%)                                       Performance (%)
                                                                                                                                                        Median Percentile Rank                                           2013-15    2013 Net
                                                                                                                                                         (Last (Latest vs. Last                            Normalised   EPS CAGR      debt/
Rank   Company Name               GICS Industry Group                             Country              Price       Mcap ($mn)    MS Rating     Latest    8Yrs)      8 Yrs)         Latest 12m Forward         P/E          (%)       Equity     -1Y       -5Y
1      SUBSEA 7                   Energy                                          Norway            NOK125.50          7,258    Equal-Weight      7.7     15.6           1.0      12.9       1.1     2.4          7.0        42.9        0.1      -17        40
2      ARCELORMITTAL              Materials                                       France                 €10.10       21,334    Underweight       2.3      7.5           1.1      24.0       0.4     1.7          5.7       151.2        0.4      -29       -80
3      BP                         Energy                                          United Kingdom           £4.46     130,903    Underweight      12.1     18.7           0.0       8.1       1.0     5.4          5.3         8.3        0.2      -11       -13
4      ANGLO AMERICAN (GB)        Materials                                       United Kingdom         £15.36       32,081    Equal-Weight      6.5     17.0           0.0      11.8       0.8     3.6          4.5         8.4        0.3      -28       -47
5      BOLIDEN                    Materials                                       Sweden             SEK101.30         4,004    Equal-Weight      8.0     16.7           6.2      13.5       1.1     2.7          6.6        31.9        0.3      -14      143
6      OC OERLIKON CORP NAMEN     Capital Goods                                   Switzerland          SFr11.75        4,030          -          13.2     17.0         11.4       16.0       1.8     2.5        10.4         11.4       -0.5       21       -68
7      RENAULT                    Automobiles & Components                        France                 €54.09       21,092     Overweight       8.6      9.0         37.2        7.0       0.6     3.3          6.5        33.6        0.0       27        -5
8      ENI                        Energy                                          Italy                  €17.52       82,822     Overweight      10.8     11.9           3.2      10.5       1.0     6.2          8.6        11.4        0.2      -11       -20
9      HEIDELBERGCEMENT           Materials                                       Germany                €53.25       12,995    Equal-Weight     30.9     64.1           9.3      12.5       0.7     2.2          1.1        13.7        0.5       11       -25
10     VEOLIA ENVIRONNEMENT       Utilities                                       France                 €11.88        8,437     Overweight       3.5      9.4           0.0      22.9       0.8     5.8          8.3        34.8        1.1       19       -68
11     VALLOUREC                  Capital Goods                                   France                 €46.33        7,560    Equal-Weight      6.8     14.5         13.5       15.7       1.1     2.4          7.5        23.2        0.4        9       -50
12     PORSCHE AUTOMOBIL HLDG V   Automobiles & Components                        Germany                €65.22       12,844          -          10.9     11.3         43.4        5.4       0.6       -          5.2         8.4       -0.2       31       -23
13     METRO STAMM                Food & Staples Retailing                        Germany                €28.48       11,957     Overweight      16.4     31.6         10.4       14.4       1.5     3.4          4.8       549.6        1.1        1       -26
14     WACKER CHEMIE              Materials                                       Germany                €76.12        5,108    Underweight       3.6     17.6           8.2      46.9       1.6     0.7          9.3        67.4        0.5       22       -42
15     MICHELIN                   Automobiles & Components                        France                 €73.71       17,871          -          24.3     34.8         30.2        8.5       1.3     3.5          3.7         7.7        0.1       10        68
16     RIO TINTO PLC              Materials                                       United Kingdom         £30.35       64,046    Equal-Weight     15.8     23.6           4.1       8.3       1.3     4.1          5.7         8.6        0.6       -9       -31
17     HOCHTIEF                   Capital Goods                                   Germany                €55.04        5,451    Underweight       0.3     12.4           0.0      14.9       1.3     3.4        10.8          6.6        0.2       24        -6
18     VEDANTA RESOURCES          Materials                                       United Kingdom         £11.89        4,819    Equal-Weight      8.3     23.3           4.2      13.6       1.1     3.2          4.9        34.4        1.9       17       -34
19     AHOLD (KON.)               Food & Staples Retailing                        Netherlands            €12.46       16,868    Equal-Weight     13.3     16.4           9.3      12.8       1.7     4.0        10.4          6.7       -0.1        8        48
20     NOKIA CORP                 Technology Hardware & Equipment                 Finland                  €2.96      14,452       NAV           16.5     14.9         60.4       35.0       1.5     0.6          9.9       159.8       -0.3        5       -83
21     ITV                        Media                                           United Kingdom           £1.69      10,073     Overweight      36.5     40.3           5.2      14.6       4.3     2.5        10.7          6.0       -0.1       68      271
22     STATOIL                    Energy                                          Norway            NOK134.60         70,448    Equal-Weight     13.7     20.8           0.0       8.9       1.2     5.1          5.8         3.2        0.2      -18       -17
23     SAINT-GOBAIN               Capital Goods                                   France                 €36.00       25,767    Equal-Weight      6.9      9.9           9.3      14.3       1.0     3.7        10.1         16.4        0.4       10        -8
24     FUGRO CERT                 Energy                                          Netherlands            €46.60        5,080          -          24.1     25.3         18.7       13.3       1.7     3.5          6.9         8.2        0.3      -13         0
25     EADS                       Capital Goods                                   France                 €44.65       45,252     Overweight       6.7     10.7           1.0      12.7       3.0     2.7        27.8         14.8       -0.7       26      175
26     BHP BILLITON PLC           Materials                                       United Kingdom         £19.21       61,734     Overweight      16.0     29.3           0.0      11.2       1.7     4.3          5.9         6.7        1.1      -15        10
27     WILLIAM DEMANT HOLDING     Health Care Equipment & Services                Denmark            DKK491.80         4,849    Equal-Weight     26.4     52.0           0.0      19.1       5.1     0.0          9.8         7.0        0.5      -15        99
28     PETROFAC                   Energy                                          United Kingdom         £14.10        7,457     Overweight      31.3     36.2         14.1       10.1       3.2     3.4          8.7         7.7        0.2      -18      140
29     HEINEKEN HOLDING           Food Beverage & Tobacco                         Netherlands            €46.19       17,345          -          14.2     18.8           0.0      12.6       1.3     2.2          7.0         7.9        1.3        6        50
30     BG GROUP                   Energy                                          United Kingdom         £12.40       65,019     Overweight      12.3     16.5           5.2      14.3       1.8     1.5        10.7          8.1        0.3      -14         7
31     SAP STAMM                  Software & Services                             Germany                €56.11       90,619     Overweight      23.5     25.5           0.0      15.6       3.7     1.8        14.4          6.1        0.0       -5        48
32     SANOFI                     Pharmaceuticals Biotechnology & Life Sciences   France                 €74.40      127,193     Overweight      13.5     14.6           7.2      12.5       1.6     4.0        11.1          6.4        0.1       -2        51
33     AP MOLLER MAERSK B         Transportation                                  Denmark          DKK48800.00        36,325    Equal-Weight      8.7     11.0         26.0        9.7       0.9     2.7          8.2        12.4        0.4        6       -16
34     ALSTOM                     Capital Goods                                   France                 €26.76       10,832    Equal-Weight     16.2     21.5           0.0       8.4       1.4     3.5          6.4         3.4        0.4      -17       -62
35     SCANIA B                   Capital Goods                                   Sweden             SEK132.80        15,732       NAV           18.2     20.7         15.6       14.9       2.7     3.8        13.2          8.0       -0.1        3        41
36     GROUPE EUROTUNNEL          Transportation                                  France                   €5.64       4,078    Equal-Weight      9.0     16.7         10.4       84.7       1.4     2.7          8.7       142.7        1.7      -15       -41
37     SULZER                     Capital Goods                                   Switzerland         SFr138.20        4,976          -          12.9     13.6         32.2       13.8       1.7     2.6        12.8         12.4        0.0       -9        -3
38     RANDGOLD RESOURCES         Materials                                       United Kingdom         £50.65        7,296     Overweight      10.8     13.9         18.6       20.3       2.2     0.7        15.9         26.7        0.0      -28      112
39     OMV AG                     Energy                                          Austria                €35.25       15,077    Equal-Weight     10.3     13.5           0.0       8.1       0.8     3.6          6.1         0.7        0.2       20       -16
40     TOTAL                      Energy                                          France                 €42.39      131,385     Overweight      14.2     18.2           0.0       8.3       1.2     5.7          6.5         1.6        0.2       -4       -13
41     MEDIASET                   Media                                           Italy                    €3.16       4,836    Equal-Weight      7.8     11.7           4.1      36.5       1.6     1.4        13.4         94.5        0.7       65       -37
42     NOKIAN RENKAAT             Automobiles & Components                        Finland                €35.89        6,204          -           3.9     20.3           5.7      12.8       2.8     5.3        13.6          6.0       -0.1       -3        45
43     ANDRITZ                    Capital Goods                                   Austria                €41.90        5,720          -          23.3     24.7         35.4       16.6       3.7     3.1        14.9         11.9       -0.7      -11      101
44     ABB LTD                    Capital Goods                                   Switzerland          SFr20.13       49,303    Underweight      18.7     20.7         19.7       13.8       2.6     3.6        12.3          8.1        0.1        7       -20
45     FRAPORT                    Transportation                                  Germany                €49.27        5,944    Equal-Weight     10.5     15.0           0.0      17.8       1.4     2.7          9.4         7.7        1.3       -6        11
46     ENEL GREEN POWER           Utilities                                       Italy                    €1.60      10,531          -           7.3     14.0           0.0      14.8       1.0     2.1          7.2         4.9        0.7        7         -
47     CLARIANT                   Materials                                       Switzerland          SFr15.30        5,361     Overweight      11.2     13.1         20.8       12.7       1.4     2.5        11.0         11.4        0.4       20        58
48     TENARIS (IT)               Energy                                          Italy                  €16.92       26,017          -          13.7     16.1         11.4       14.3       1.9     2.2        12.0          5.6        0.0      -10        -8
49     THALES                     Capital Goods                                   France                 €37.84        9,948     Overweight      13.2     14.2         37.5       11.0       1.5     2.7        10.2          5.8       -0.3       24        -2
50     PRYSMIAN                   Capital Goods                                   Italy                  €17.15        4,755          -          21.9     24.3           5.4      12.0       2.6     2.6        10.8          9.7        0.7       12         2
51     ASML HLDG                  Semiconductors & Semiconductor Equipment        Netherlands            €67.23       39,076     Overweight      19.7     23.1         25.2       21.4       4.3     0.9        18.4         25.7       -0.2       25      286
52     BOUYGUES ORD               Capital Goods                                   France                 €23.73        9,961    Equal-Weight      8.4     14.3           0.0      10.4       0.9     6.2          6.1         3.1        0.5        1       -38
53     ELECTROLUX B               Consumer Durables & Apparel                     Sweden             SEK179.50         8,200          -          17.9     20.9         14.5       12.6       2.7     4.0        12.8         16.4        0.5        1      113
54     CGG                        Energy                                          France                 €18.00        4,189    Underweight       7.1      8.7         41.6       12.3       0.9     0.0        10.1         22.7        0.4      -25       -27
55     ORKLA                      Food Beverage & Tobacco                         Norway              NOK44.47         7,397          -           9.3     11.0         13.5       15.9       1.5     5.8        13.6         11.5        0.4       -9       -36
56     AKER SOLUTIONS             Energy                                          Norway              NOK92.00         4,182          -          17.5     20.2         34.3       10.3       1.8     4.5          8.9        26.2        0.6      -21       -12
57     VOLVO B                    Capital Goods                                   Sweden              SEK96.40        30,743    Equal-Weight     14.7     16.6         24.4       15.0       2.3     3.5        13.7         38.0        0.4        0        26
58     YARA INTERNATIONAL         Materials                                       Norway            NOK245.00         11,079    Equal-Weight     14.7     18.7           4.1       8.5       1.2     4.5          6.5        -1.8        0.0      -23       -24
59     CARREFOUR                  Food & Staples Retailing                        France                 €24.36       22,615     Overweight      12.5     16.3           9.3      15.0       1.9     3.0        11.6          8.0        0.5       25       -22
60     HOLCIM                     Materials                                       Switzerland          SFr64.05       22,108    Equal-Weight     17.6     17.5         53.1       12.9       1.1     2.6          6.3        12.2        0.6       -5       -10
61     SMITH & NEPHEW             Health Care Equipment & Services                United Kingdom           £7.66      10,492    Equal-Weight     17.8     22.9         12.5       14.7       2.6     2.4        11.3          5.0        0.1        0        18
62     FIAT ORD                   Automobiles & Components                        Italy                    €5.81       9,417          -           5.6      7.4         41.6       12.5       0.7     0.9          9.1        36.3        0.8       17        26
63     INFINEON TECHNOLOGIES      Semiconductors & Semiconductor Equipment        Germany                  €7.03       9,780    Equal-Weight     23.5     16.4        100.0       17.5       1.9     2.0        11.4         32.9       -0.5        5        27
64     ZARDOYA OTIS               Capital Goods                                   Spain                  €11.19        6,150          -          41.2     97.6           3.1      25.2      10.2     3.8        10.5          1.5        0.0       12         3
65     ROYAL DUTCH SHELL B        Energy                                          United Kingdom         £21.65      209,160    Equal-Weight     13.3     15.1         15.6        8.5       1.1     5.3          7.5         3.3        0.2      -16        19
66     ASTRAZENECA                Pharmaceuticals Biotechnology & Life Sciences   United Kingdom         £31.83       61,953    Underweight      26.9     34.2           3.1      10.0       2.7     5.7          7.8        -3.9        0.0       -5        20
67     CARNIVAL PLC               Consumer Services                               United Kingdom         £24.23        8,128    Equal-Weight      6.6      9.2           4.1      18.5       1.2     2.8        13.5         20.5        1.3       -2        29
68     UPM-KYMMENE                Materials                                       Finland                  €9.32       6,370    Equal-Weight      5.9      6.6         30.2       11.2       0.7     6.5        10.0          8.0        0.4       -9       -21
69     VOLKSWAGEN STAMM           Automobiles & Components                        Germany               €172.30      104,078     Overweight      12.1      9.9         74.1        7.1       0.9     2.8          8.8         7.5       -0.1       11       -17
70     BARRY CALLEBAUT            Food Beverage & Tobacco                         Switzerland         SFr884.50        5,143          -          14.3     18.0           0.0      17.3       2.4     2.0        13.3          6.8        0.8      -18        26
71     ANTOFAGASTA                Materials                                       United Kingdom           £8.86      13,119    Underweight      12.4     22.8           8.4      15.8       1.8     2.5          7.8        -4.4       -0.2      -32        44
72     CASINO ORD                 Food & Staples Retailing                        France                 €72.75       10,664    Equal-Weight      7.2      8.5           0.0      12.3       0.9     4.6        10.7          5.3        0.9      -12        16
73     COLRUYT                    Food & Staples Retailing                        Belgium                €42.26        9,308    Equal-Weight     19.0     25.4           9.3      16.7       3.2     2.5        12.5          3.2       -0.3       -3        12
74     RANDSTAD HOLDING           Commercial & Professional Services              Netherlands            €35.60        8,212          -          13.9     15.5         29.1       14.5       2.0     3.2        13.2          9.0        0.3       19        66
75     STORA ENSO R               Materials                                       Finland                  €5.95       6,139    Equal-Weight      5.9      6.6         31.2       13.1       0.8     5.2        12.2         30.5        0.6        4       -16
76     VOESTALPINE                Materials                                       Austria                €32.80        7,363    Equal-Weight     10.5     13.7         22.9       10.8       1.1     2.9          8.2         6.9        0.7       21       -12
77     ERICSSON (LM) B            Technology Hardware & Equipment                 Sweden              SEK78.60        38,820     Overweight       3.9      4.8         26.0       14.8       1.7     3.9        36.6         13.9       -0.3       10         7
78     FRESNILLO PLC              Materials                                       United Kingdom         £12.75       14,944          -          11.3     13.1           0.0      33.7       5.1     1.8        38.8          5.2       -0.2      -29      227
79     DASSAULT SYSTEMES          Software & Services                             France                 €96.60       16,077     Overweight     -14.4     25.1         12.6       24.9       4.1     1.0        16.4          5.0       -0.6       11      134
80     E. ON                      Utilities                                       Germany                €12.08       31,615    Equal-Weight     12.3     28.6         10.4        9.8       0.6     5.7          2.2        -0.3        0.3      -41       -69


For important disclosures regarding covered companies that are the subject of this screen, please see the Morgan Stanley Research Disclosure Website at
www.morganstanley.com/researchdisclosures.For important disclosures regarding non-covered companies that are the subject of this screen, please refer to the Disclosure Section, located at the end
of this report. A=Attractive, I=In-line, C=Cautious. Prices are updated as of 02 September 2013.
Source: MSCI, IBES, Factset estimates, Morgan Stanley Research




                                                                                                                                                                                                                                                                  22
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                                                                                                            European Strategy




European Model Portfolio Changes

Today we make some changes to our portfolio. Primarily these                                                Discretionary’s share at 23% made it the biggest sector in the
reflect our concern that the market faces some near-term                                                    list in absolute terms (along with Industrials) and the biggest
headwinds and that short-term risks are skewed to the                                                       relative to history (at the 94th percentile and not far off its
downside.                                                                                                   record high). Exhibits 64 and 65 also show the sector at the
                                                                                                            very top of its long-term historic range on both relative
Telecoms raised to Neutral                                                                                  percentile valuations and normalized PE.
We move from Underweight to Neutral in Telecoms. That takes
our overall weighting in Defensives to a neutral positioning also                                           Financials: Insurance up to OW & Diversified Financials
and should provide some protection to our portfolio should the                                              down to Neutral
market correction continue. While growth fundamentals for the                                               We maintain our overall weighting in Financials unchanged,
sector remain challenging we are encouraged that                                                            keeping our OW in Banks, but raising Insurance to OW while
expectations (and in some cases dividends) have been re-set                                                 cutting Diversified Financials & Real Estate to Neutral.
over the last 1-2 years. In fact, we note the recent apparent                                               Insurance has tended to perform more resiliently in risk-off
bottoming in DPS revisions for the sector (exhibit 67).                                                     periods in this cycle. Moreover, the group’s valuation is the
Increasing sector consolidation is another theme that provides                                              cheapest versus history of all industry groups in Europe and
some potential upside risk. Regulation remains a downside risk                                              recent underperformance provides an attractive entry point.
(given upcoming EC legislation on roaming / international calls).                                           We also like the relatively good combination of dividend yield,
However, our analysts believe the final outcome will be benign                                              DPS growth and modest payout ratio the sector offers. We note
relative to expectations.                                                                                   that 10 of the 40 names in our screen of ‘stocks offering value
                                                                                                            and growth’ in exhibit 61 are Insurers.
Consumer Discretionary cut to Neutral
As discussed on pages 19-20 we recommend a more cautious                                                    Stock changes
stance on Cyclicals in the near-term and with that in mind we                                               Within Telecoms we are adding Ziggo.
downgrade Consumer Discretionary to Neutral. We note that
Consumer Discretionary was the most prominent sector in the                                                 Within Consumer Discretionary we are selling Renault. Our
‘Multiple Appearances’ screen within our recent Sellers’                                                    Autos analyst highlight that the latter has relatively high
Compendium product Sellers’ Compendium: Sell screens                                                        exposure to slowing growth and FX depreciation in EM.
support our tactical caution‘ 19 August 2013. Consumer


Exhibit 63
European Model Portfolio

                               OVERWEIGHTS                                                       NEUTRALS                                                             UNDERWEIGHTS
                                        Benchmark      Portfolio                                            Benchmark      Portfolio                                                     Benchmark      Portfolio
Sector                                  Weight (%)   OW / UW (%pt)   Sector                                 Weight (%)   OW / UW (%pt)   Sector                                          Weight (%)   OW / UW (%pt)
Banks                                        11.0        +2.0        Consumer Discretionary                    9.8            0.0        Consumer Staples                                   14.1          -2.0
Barclays*, BNP, KBC, Swedbank                                        Accor, IHG, Volkswagen                                              Carrefour, DIA, Imperial Tobacco, Nestle, SCA
Health Care                                  12.6        +2.0        Diversified Financials & Real Estate      5.0            0.0        Industrials                                        11.5          -2.0
Novartis, Roche, Sanofi, UCB                                         British Land, UBS                                                   IAG, Rexel, Ryanair
Insurance                                    5.5         +2.0        Energy                                    9.7            0.0        Materials                                          8.1           -2.0
Aegon, Allianz, Prudential                                           ENI, RD Shell, Tullow                                               BASF, Rio Tinto, Solvay*
                                                                     Information Technology                    3.1            0.0
                                                                     SAP, United Internet
                                                                     Telecommunication Services                5.8            0.0
                                                                     Orange, Vodafone*, Ziggo
                                                                     Utilities                                 3.9            0.0
                                                                     EDP, Gas Natural



Source: Morgan Stanley Research
*Note: Although the shares of this company remain in the model portfolio, Morgan Stanley & Co. International plc policy precludes the exercise of investment management discretion or the rendering of
investment advice on the shares at this time by the strategist and/or the Morgan Stanley analyst who follows the shares.

Prices as of 2 September 2013: VODAFONE GROUP (£ 2.11)TULLOW OIL (£ 10.30) NOVARTIS (SFr 70.15) ROCHE HOLDING GENUSS (SFr 236.50) SANOFI (€ 73.99) IMPERIAL TOBACCO
GROUP (£ 21.42) SAP STAMM (€ 6.08) PRUDENTIAL (£ 11.08) RIO TINTO PLC (£ 30.66) RYANAIR HOLDINGS (€ 6.83) SWEDBANK (SEK 154.30) BARCLAYS (£ 2.88)INTERCONTINENTAL
HOTELS (£ 18.39) ROYAL DUTCH HELL B (£ 21.63) UBS NAMEN (SFr 18.72) BNP PARIBAS (€ 48.92) ALLIANZ (€ 110.00) NESTLE (SFr 61.40) UCB (GROUPE) (€ 44.32) BRITISH LAND CO
(£ 5.61) CARREFOUR (€ 24.41) DIA € 6.12) SCA SV CELLULOSA B (SEK 166.40) SOLVAY (€ 106.65) BASF (€ 67.77) GAS NATURAL SDG (€ 14.85) ORANGE (€ 7.92) ENI (€ 17.47) KBC
GROUPE (€ 34.25) RENAULT (€ 54.15) AEGON (€ 5.48) REXEL (€ 17.95) ACCOR (€ 17.95) VOLKSWAGEN VORZUG (€ 174.60) UNITED INTERNET (€ 26.82) EDP ENERGIAS DE PORTUGAL (€
2.69) INT'L AIRLINES GROUP (€ 3.52) ZIGGO (€ 29.99)




                                                                                                                                                                                                                      23
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                                                                                                                                                                                                September 4, 2013
                                                                                                                                                                                                European Strategy




Exhibit 64                                                                                                                                                                                      Exhibit 66
Consumer Discretionary trades close to a record                                                                                                                                                 Telecoms’ relative normalized PE is close to 7-year
high on relative normalized PE                                                                                                                                                                  lows and relative price performance is close to
                                                                                                                                                                                                30-year lows
                                            50                                                                                                               160
                                                                                              Normalised PE - % Premium / Discount vs MSCI Europe
                                                                                              Relative Price Performance (RHS)                                                                                                              150                                                                                                          330
 Normalised PE - % Premium / Discount vs MSCI




                                            40                                                                                                                                                                                                                    Normalised PE - % Premium / Discount vs MSCI Europe
                                                                                                                                                             140                                                                                                  Relative Price Performance (RHS)




                                                                                                                                                                                                 Normalised PE - % Premium / Discount vs MSCI
                                            30                                                                                                                                                                                                                                                                                                           280




                                                                                                                                                                   Relative Price Performance
                                                                                                                                                                                                                                            100
                                                                                                                                                             120




                                                                                                                                                                                                                                                                                                                                                               Relative Price Performance
                                            20
                                                                                                                                                                                                                                                                                                                                                         230
                    Europe




                                            10                                                                                                               100                                                                                50




                                                                                                                                                                                                                    Europe
                                                                                                                                                                                                                                                                                                                                                         180
                                                0
                                                                                                                                                             80
                                                                                                                                                                                                                                                 0
                                      -10                                                                                                                                                                                                                                                                                                                130
                                                                                                                                                             60
                                      -20                                                                                                                                                                                                       -50
                                                                                                                                                                                                                                                                                                                                                         80
                                      -30                                                                                                                    40
                                                    84        86        88        90    92    94    96    98    00    02   04    06     08     10     12
                                                                                                                                                                                                                                      -100                                                                                                               30
                                                                                                                                                                                                                                                      84     86      88      90   92    94      96   98    00      02   04    06      08   10    12
Source: MSCI, Morgan Stanley Research

                                                                                                                                                                                                Source: MSCI, Morgan Stanley Research


Exhibit 65
On percentile valuations Consumer Discretionary is                                                                                                                                              Exhibit 67
at its highest level since 1986                                                                                                                                                                 Telecoms’ relative price performance has lagged its
                                                 MSCI Europe Consumer Discretionary - Percentile Of Current Relative Valuation vs History
                                                                                                                                                                                                relative dividend revisions ratio
      100                                                                                                                       Sector at most expensive
                                                                                                                                                                                                      10                                                                                                                                                       115
                                                                                                                                relative levels vs history
                 90

                 80                                                                                                                                                                                                                                                                                                                                            110
                                                                                                                                                                                                                 5
                 70
                                                                                                                                                                                                                                                                                                                                                               105
                 60

                 50                                                                                                                                                                                              0
                                                                                                                                                                                                                                                                                                                                                               100
                 40

                 30                                                                                                                                                                                                                                                                                                                                            95
                                                                                                                                                                                                           -5
                 20
                                                                                                                                         Sector at cheapest                                                                                                                                                                                                    90
                 10
                                                                                                                                      relative levels vs history
                                                                                                                                                                                                 -10
                            0
                                            82           84        86        88        90    92    94    96    98    00    02   04     06     08     10      12                                                                                                                                                                                                85
                                                                                                                                                                                                                                                           Telcos Relative N12M Dividends Revisions Ratio 3MA (%)
                                                                                                                                                                                                                                                           Telcos Relative Performance (RHS)
Source: MSCI, Morgan Stanley Research                                                                                                                                                            -15                                                                                                                                                           80
                                                                                                                                                                                                   Jan-11                                              Apr-11       Jul-11    Oct-11   Jan-12    Apr-12   Jul-12    Oct-12   Jan-13    Apr-13   Jul-13


                                                                                                                                                                                                Source: MSCI, IBES, Morgan Stanley Research




                                                                                                                                                                                                                                                                                                                                                                                            24
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                                                                                  European Strategy




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                                                                                                                                                               25
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                                                                                 European Strategy




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                                         % of                   % of % of Rating
Stock Rating Category        Count       Total     Count Total IBC Category
Overweight/Buy                978        34%         400         38%         41%
Equal-weight/Hold            1280        44%         491         46%         38%
Not-Rated/Hold                114         4%          28          3%         25%
Underweight/Sell              510        18%         137         13%         27%
Total                       2,882                   1056
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                                                                                                                                                             26
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Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant
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Description: More upside, after a pause