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Emerging market equities
Preference: overweight

UBS View
MSCI EM (24 Oct.): 995 (last publication: 990)
MSCI EM 6-month target: 1,040

• The downward revisions to the emerging market GDP growth forecasts appear to be coming to an end. We expect emerging market GDP growth to accelerate to 5.3% in 2013 from this year's 4.7%.
• Monetary policy in the US, the Eurozone, and Japan remains supportive. One implication of these low interest rate policies, we believe, will be to enhance emerging market (EM) equity returns in USD by supporting EM currencies more broadly against the USD over the next six months.
• In our base case, we see the P/E multiple of the MSCI EM Index staying around the current level of 11x trailing (i.e. realized) earnings over the next six months. Over the next 12 months, we expect EM earnings growth of around 11% (slightly below consensus).
• Over the past month, structural reforms that will have longer-term benefits were announced in India (retail sector), Russia (energy sector) and Mexico (labor market). This highlights that the emerging economies have options to improve the competitiveness of their economies, if they choose to do so.

Positive scenario
MSCI EM (6-month target): 1,325
• The outlook for the global economy improves, boosting EM's ability to grow more strongly in 2013. This stronger economic growth leads to earnings growth of 15%. Investor confidence improves, leading to a better P/E multiple of 14x trailing earnings. If oil prices rose too, Russia would benefit in this scenario.

Negative scenario
MSCI EM (6-month target): 800
• A significant escalation in the Eurozone, a sharp fiscal contraction in the US, and a rapid deceleration in Chinese growth could each hit EM's economic prospects. In such a scenario, we would expect a 20% decline in earnings over six months. More defensive Malaysia would do better, whereas more cyclical South Korea and Russia would underperform. We assume, however, that the market would also be expecting some recovery in earnings for 2014, helping the P/E multiple to recover to 10x trailing earnings.
Note: Scenarios refer to global economic scenarios (see slide 7)

What we're watching
Emerging market monetary policy
Why it matters
Investors are trying to figure out which emerging market central banks still have room to ease monetary policy and where rates may be heading up. Inflation data is due for Russia (6 Nov), Brazil (7 Nov), China (9 Nov), India (14 Nov) and South Africa (21 Nov).

Food and oil prices
The prices of grains and oil are higher than this time last year. For now, negative output gaps should counterbalance some of this inflationary pressure.

Recommendations
Tactical (6 months)
• Within emerging markets, we have a preference over six months for the large equity markets, Brazil, China and South Korea. We expect an acceleration of growth into 2013 in Brazil and South Korea, and a stabilization in the case of China. We see relatively less upside for more defensive Malaysia. We believe that South Africa and Indonesia are expensive. The ECB's announcement that it stands ready to buy the bonds of compliant Eurozone governments has lessened the tail risks for the smaller European emerging equity markets (Turkey, Hungary, Poland), but their equity markets are susceptible to setbacks.

Strategic (1 to 2 years)
• Strategically, we would advise that EM portfolios tilt toward cash-rich and faster-growing Asia.

Country preferences within emerging markets (relative to MSCI EM)

Current most preferred markets
Brazil
China
South Korea

Current least preferred markets
Indonesia
Malaysia
South Africa

UBS
For further information please contact CIO asset class specialist Costa Vayenas, costa.vayenas@ubs.com
Please see important disclaimer and disclosures at the end of the document.
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