MORGAN STANLEY RESEARCH

November 29, 2010

European Strategy

Exhibit 65
Three Key Surprises for 2011 Insurance under-owned – consensus position based
on EPFR industry group allocation survey –
Ronan Carr, CFA percentage point deviation from benchmark

Key surprises. Each year we identify a selection of key

1.5
surprises. We have one surprise for each of our bull, bear and
base case macro scenarios. The surprises in each case refer to 1.0
heavily out-of-consensus trades, where we think the probability
of each is higher than markets currently discount, given the 0.5

three sets of macro assumptions.

0.0

Base case surprise: Insurance to outperform in 2011 -0.5

Our base case surprise is that the insurance sector

-1.0
meaningfully outperforms MSCI Europe in 2011. Our Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10

conversations with investors suggest that there is widespread

scepticism about the Insurance sector, particularly against a Source: EPFR, Morgan Stanley Research
backdrop of low interest rates. Our positioning data confirm Note: Industry group and sector allocation surveys are based on different fund samples, due to
not all funds reporting down to the industry group level.
that the sector continues to be under-owned (Exhibit 65). In
Exhibit 66
addition, the sector performance has been in the doldrums for
Insurance sector not far off all-time relative lows
much of the last five years (Exhibit 66). In fact, the sector is
300
within 5% of the February 2009 all-time relative lows (on a total
return basis).
250

Rising bond yields the key trigger. So why might the sector
200
do better next year? The key catalyst, in our view, is our
expectation that bond yields are likely to rise. Empirically we
150
have found a strong link between the sector’s relative
Insurance total return index
performance and significant moves in bond yields, relative to MSCI Europe
100
outperforming when they rise – such as in 2009 and vice versa
(Exhibit 67). Fundamentally, very low bond yields are a
50
significant handicap for the insurance sector as they imply
Jan-73

Jan-75

Jan-77

Jan-79

Jan-81

Jan-83

Jan-85

Jan-87

Jan-89

Jan-91

Jan-93

Jan-95

Jan-97

Jan-99

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09
lower investment returns. Low yields are particularly
problematic in the life sector due to the guarantees they Source: MSCI, Morgan Stanley Research

typically offer on their liabilities. Higher yields could shift Exhibit 67

perceptions of the sector’s potential profitability higher. Rising bond yields would support Insurance
110 5.5
Valuation is depressed, DY attractive. Insurance is one of
105
the cheapest sectors in the European market on several 5.0

measures. Relative P/BV and P/E multiples are at all-time low 100
4.5
Relative Perf rebased to 100

levels and 1.1SD below the 10-year average. Based on 95

4.0
consensus 2011 estimates for P/E, P/BV and DY, insurance
Bond Yield %

90

ranks first, second and third cheapest, respectively, of the 24 3.5

85
industry groups. The 5.2% DY in 2011 is 42% above the market 3.0
80
level and many insurers qualify on our high and secure
2.5
dividend yield screen. With FCF yields of 7-8% we think the 75
Insurance relative to MSCI Europe
dividends are sustainable. 70 US Treasuries (RHS)
2.0

65 1.5
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Boring but solid fundamentals. Insurance suffers from a low
Source: FactSet, MSCI, Morgan Stanley Research
growth reputation given the interest rate environment and low
EM exposure. However, in 2011 consensus forecasts see

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 MORGAN STANLEY RESEARCH

November 29, 2010

European Strategy

insurance EPS growth converging with the market (+16% EM proxies’ strong performance this year has coincided
versus +18%). Recently earnings revisions momentum has with surging earnings momentum. Sector performance year
been accelerating, which traditionally correlates with to date has been tightly correlated with earnings revisions
outperformance. In the non-life segment, prices are rising (Exhibit 70). Those sectors enjoying revisions ratios that were
modestly, with strongest momentum in the UK, Italy and superior to the market (led by EM proxies) generally
France. outperformed and vice versa. Hence, we would expect any
reversal in earnings momentum to hit the shares prices of EM
Exhibit 68 proxies hard.
Relative valuations – are valuations high or low
versus historical range? Valuations for many EM related stocks and sectors look
Latest Relative Multiples (%tile, Relative to all Data since
1973) very stretched. Such sectors could see a significant de-rating
Industry Group P/D P/S P/B P/E Avg ex PE
Insurance 6 - 0 0 3 in the event of a double dip, we believe. Comparing current
Technology Hardware & Equipment 4 7 5 85 5
Media 6 27 32 71 22
trailing valuation multiples relative to MSCI Europe we find that
Pharmaceuticals Biotechnology & Life Sciences
Software & Services
0
32
26
33
52
22
6
37
26
29
Consumer Durables trades on all-time high levels of P/BV,
Telecommunication Services 19 5 74 21 32 P/dividend and P/sales (Exhibit 66). The other sectors trading
Utilities 37 9 56 23 34
Food & Staples Retailing 52 9 47 57 36 in the top quartile of their historical range include many EM
Banks 73 - 1 82 37
Household & Personal Products 8 41 66 43 38 proxies (Materials, Capital Goods, Staples, Autos).
Energy 48 11 58 93 39
Health Care Equipment & Services 27 23 75 57 42
Diversified Financials
Consumer Services
95
76 6
- 8
100
8
39
51
60
EM proxies are generally over-owned. Our survey of
Transportation 96 9 78 79 61 investor positioning suggests the three most over-owned
Real Estate 67 - 70 96 69
Semiconductors & Semiconductor Equipment 49 80 83 36 71 sectors are Consumer Discretionary, Industrials and
Retailing 23 92 99 33 71
Automobiles & Components 100 78 71 84 83 Technology (Exhibit 71).
Commercial & Professional Services 97 73 98 89 89
Food Beverage & Tobacco 81 94 97 85 91
Capital Goods 99 79 100 92 93
Materials 100 100 98 97 99
Trade implications. At the sector level, we would classify the
Consumer Durables & Apparel 100 100 100 89 100
major EM proxies as consumer durables, industrials, autos,
MSCI Europe 64 75 45 60 61 materials and parts of technology. Under this scenario, such
Source. MSCI, Datastream, Morgan Stanley Research
Note: Table shows latest relative valuation multiples for sectors (absolute multiples for market), groups could severely underperform as they face a double
expressed in percentile terms against all valuation history since 1973.
whammy of declining earnings and a multiple de-rating.

Bear case surprise: EM proxies the biggest Exhibit 69

underperformers in 2011 GEG basket >35% EM revenues basket vs broad
market indices
Our bear case scenario involves a double dip in the global
economy because of some combination of stimulus withdrawal,
inflation, trade frictions or sovereign debt concerns. This
250.0

MSCI Europe

scenario would involve a material disappointment in earnings 230.0 MSCI EM (USD)

GEG Basket

expectations. Under this scenario, we think EM related stocks 210.0

could be among those most negatively affected. While this may 190.0
Index - = 100 on 31/12/04

be expected, given that many EM proxies are in cyclical sectors, 170.0

we think the effect could be magnified by the starting point of 150.0

fairly demanding valuations (if growth falls short of estimates), 130.0

high expectations and extended positioning. 110.0

90.0

EM related stocks and sectors have been big 70.0

outperformers this year. The median stock in our EM basket 50.0

Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09

(based on stocks with EM revenue exposure of at least 35%) is Source. Datastream, MSCI, Morgan Stanley Research
up 16.9% this year versus 4.6% for the median stock more
broadly. In addition, the best performing industry groups year
to date are Consumer Durables, Autos, Semis, Capital Goods
and Retailing, all of which have a significant EM exposure.

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 MORGAN STANLEY RESEARCH

November 29, 2010

European Strategy

Exhibit 70
Stronger earnings revisions for EM proxies drove Bull case surprise: Spain rebounds
outperformance The key surprise in our bull case scenario is a rebound in
50
Spanish markets. Views on Spain currently are dominated by
Con Dur/App
40
Autos
concerns on growth potential, leverage, the banking sector and
Sector return YTD versus MSCI Europe (%)

sovereign stresses in the euro zone periphery. Our bull

Stronger earnings revisions for EM
30

Semis
proxies drove outperformance
scenario assumes stronger than expected global growth,
20
continued accommodative monetary policy and European
Cap Goods
Consu Serv Retail
Food, Bev
authorities stabilising bank and sovereign debt markets
Hous/Pers Prod
Software .Comm Serv Materials
10
Transport Food Retail Media (perhaps via QE). This implies a much reduced risk of
Telcos Hlth Eq/S

0
Real Estate
contagion and a funding crisis spreading to Spain. The bull
Insurance Pharma
Energy
.Div. Fin
Tech Hardware scenario would boost GDP growth in the periphery and
Utilities
-10 Banks
improve risk appetite, helping assuage fears about the
-20
EPS revisions worse than the market EPS revisions better than the market
sustainability of the current debt burden.
-10.0 -5.0 0.0 5.0 10.0 15.0
Earnings revisions ratio: sector spread versus MSCI Europe (average YTD %)

Source MSCI, IBES, Morgan Stanley Research In addition to a more supportive global growth backdrop and
policy support for peripheral Europe, we think there are some
Exhibit 71
potentially overlooked factors that give room for upside
Sectors – Relative valuations & ownership
surprise under this scenario.
compared
5.0
Expensive and Overowned Cheap and Overowned - Lower sovereign default risk. Spanish sovereign default
Consensus sector weights - % Point Deviation From Benchmark

4.0
Cons Disc (SXAP, risk is below that of other peripheral countries. Credit quality of
3.0 SXMP)
Industrials (SXNP)
IT (SX8P)
the Spanish sovereign is superior given that debt to GDP is
2.0
lower and debt service (interest expense to revenues) is lower
1.0
Health Care (SXDP) than Spain’s own history and European peers.
0.0
Materials (SXPP, SX4P) Energy (SXEP)
Cons Stap (SX3P)
-1.0 Telecomms (SXKP)

-2.0
- Larger domestic investor base. The Spanish bond market
-3.0
Utilities (SX6P)
can rely to a larger extent on domestic investors than Ireland,
-4.0
Portugal or Greece, mitigating risk of funding markets drying up.
Financials (SXIP, SX7P,
-5.0 SXFP, SX86P) Non-residents hold only 42% of Spanish government bonds.
-6.0
Expensive and Underowned Cheap and Underowned Moreover, the domestic banking sector over time would have
4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0
Relative valuations compared to 10Y moving average (z-score) - the lower the cheaper significant capacity to raise domestic sovereign debt holdings.
Source. EPFR, MSCI, Datastream, Worldscope, Morgan Stanley Research The four largest banks have €2.2 trillion of assets. Assuming
Notes: Order of EPFR consensus preference within Financials & Consumer Discretionary 20-25% of assets mature each year would mean c.
sectors. Financials: Diversified Financials (most popular), Real Estate, Insurance, and Banks
(least popular). Consumer Discretionary: Media (most popular), Autos, Consumer Durables, €450-550bn of cash available to redeploy into government
Consumer Services and Retailing (least popular)
bonds every year against issuance of c. €100bn per year. More
Valuation note: We explored many different valuation measures, including P/E, P/BV, P/CE, broadly, Spanish banks’ holdings of government bonds are
P/dividend, P/sales and combinations thereof. For each sector we chose a combination of
metrics that we felt was appropriate for each sector: P/dividend for Consumer Discretionary, only about 5% of total balance sheet compared to 9-10% in
Consumer Staples, Energy, Industrials, IT, Materials, Utilities; P/BV for Financials; P/dividend
& P/CE for Healthcare; P/CE & P/Sales for Telcos. The mapping between GICS Sectors (such 2001-03. Spanish banks could buy about €200bn Bonos before
as Healthcare) and DJ Stoxx SuperSectors – Level 3 (such as SXDP) is imperfect at places. In getting back to that level.
particular, less than two-thirds of market cap of Consumer Discretionary, Consumer Staples
and Diversified Financials is covered by the corresponding DJ Stoxx Supersectors.

- The Spanish banking system is in better shape in

aggregate than the Irish one, we believe, even if the economy
suffered similar problems (i.e. housing/construction bubble).
Spanish banking regulation is more conservative than most,
e.g. requiring counter-cyclical provisions and higher-quality
capital (the rules on risk-weighted assets are stricter). Large
banks continue to be profitable (e.g. Santander made 17%
ROE in 3Q10 despite reporting poor results). The Spanish
summer stress-test was widely considered to be credible
(unlike elsewhere) and the level of disclosure much better too.

27