>2010 GEMs Outlook: Headwinds Building But Further Upside Likely

We expect a more micro market in 2010. After two years where macro themes drove emerging equity markets, we expect a shift to a more micro market.

Earnings and Valuations. Economies and earnings are recovering and it is likely too soon in the cycle for a major peak in EM equities. However, we do face the headwinds of a) monetary policy tightening (first in Asia and then the US) and b) a higher oil price. Valuations are neither expensive (24 months ago) nor cheap (12 months ago) in our view. On our base case of 40% US$ EPS growth, MSCI EM is trading on 13.4x 2010e PER. Our scenario-weighted year-end 2010 price target for MSCI EM is 1200, representing 28% upside from current levels and 22% above our previous target price.

Country and Sector preferences. China is our biggest country OW and South Africa our biggest UW, though in general we see few mispricings to exploit at the country level. However, we believe investors can profitably take risk at the sector level. Our preferred sectors are Energy in general and Financials / Consumer Discretionary in the under-levered, faster-growing economies in Asia/EM (China, India, Brazil and Indonesia). Least favoured are Telecoms and Utilities. We are also downgrading IT to equal-weight on both valuations and its historical
sensitivity to a global rate hike cycle.

Best Business Models. We recently concluded our two-part series on Sources of Competitive Advantages in EM by naming the Best Business Models in each of 26 different industry groups. Large-cap names which make the list include: CNOOC, ENRC, Mediatek, Reliance Industries, Tencent Holdings and Walmart de Mexico.

To read the full report: GLOBAL STRATEGY