GLOBAL

2004 – The Year Ahead

8 January 2004

Global Emerging Markets

Four Themes for 2004

Contributors We prefer emerging equities to emerging sovereign debt. The former still
looks attractively valued in historic context. The latter looks less attractively
Ed Butchart valued in historic context.
Global Emerging Markets Equity
Strategist We also continue to favor emerging equities over global equities. Emerging
equities still trade at a 35% discount to world equities, yet we think long-term
Tulio Vera growth expectations for the asset class are on the rise again.
Global Emerging Markets Fixed Income
Within the emerging equity universe, we like reflation trades (such as India
Strategist
and Thailand), disinflation trades (Turkey, Brazil, domestic South Africa), and
cyclical plays (Korea and Taiwan).
Within the emerging debt universe, we favor the external debt of Venezuela,
Uruguay, and the Philippines. Brazil, Russian, and Colombia remain top
picks in the early part of the year. In local currency, we favor PLN, TRL, and
ZAR-denominated paper.

The Sweet Spot for GEM Equity

We think that a long-neglected asset class, emerging market equities, remains a
compelling investment opportunity. Emerging equities have started to outperform
global equities, yet remain relatively cheap. They should also benefit from the macro
conditions ML foresees in 2004 – namely global recovery, rising commodity prices,
a weakening dollar, and a Fed that remains on hold.
We are also struck by the disconnect between emerging market equity and emerging
market debt. The latter has had a strong performance for several years with sustained
low volatility; however, absolute valuations are edging toward the richer end of the
historic range. In contrast, emerging market equity valuations remain toward the
bottom end of the historic range.
Right now, then, emerging equities appear to be in a “sweet spot,” and we expect a
strong start to the new year. Beyond that, relative returns should be well supported
by attractive relative valuations. However, sustaining strong absolute returns requires
that the world economy remains “not too hot and not too cold.”

#1 Emerging Equity More Attractive Than Emerging Debt

The last 10 years have seen solid performance from emerging market sovereign
debt, but poor returns in equity, as Chart 1 illustrates. The ML IGOV EM Sovereign
Debt index has returned 195% since the start of 1994. By contrast, the MSCI
Emerging Markets Free index has produced a negative 2% return.

Investors should assume that Merrill Lynch is

Refer to important disclosures on page 7. seeking or will seek investment banking or other
business relationships with the companies in
Merrill Lynch Global Securities Research & Economics Group
this report.
Global Fundamental Equity Research Department
RC#40400807
Global Emerging Markets – 8 January 2004

Partly as a result of this performance discrepancy, we think that emerging

markets equity is now significantly more attractively valued than emerging
markets debt. Emerging market debt spreads over US Treasuries are currently
about 30 basis points from their all-time lows (set in October 1997), while emerging
market equities still trade toward the bottom of their historic valuation range, as
Chart 3 shows.
In short, based on historical experience, debt is relatively expensive, while
Chart 1: Equity-vs.-Debt: Total Returns
equity is relatively cheap.
300

We believe the sustained historic underperformance of emerging markets equity,

250 relative to external sovereign debt, has reflected the following factors:
200 • Firstly, sovereign debt is denominated in hard currency, while most emerging
market equities are priced in local currency, and are then translated into dollars
150
in the MSCI index. The weakness of emerging market currencies during much
100
of the last 10 years has thus eroded the returns generated by equities.
• Secondly, as we noted in the previous section, optimism on emerging market
50
growth prospects has rarely been present in the past decade. For the growth
0
opportunities offered by emerging equities to look more attractive to investors
94 95 96 97 98 99 00 01 02 03 04 than the returns offered by external debt instruments, investors need to be
EMEquities (MSCI EMFUS$ Index) EMDebt (IGOVIndex) optimistic about growth prospects.

Source: Merrill Lynch, Datastream • Thirdly, emerging equities have faced comparable challenges to emerging
markets corporate debt in the sense that when investors take on this type of
exposure they are not only taking on sovereign (or macro) risk but also
incremental corporate (or company) and sector risk. The simplicity of having to
analyze only one type of risk – sovereign – has made the latter more attractive.
Emerging debt looks relatively • One other reason for the outperformance (or perhaps the more rapid
expensive. Emerging equity development) of emerging sovereign debt is the relatively better market liquidity
looks relatively cheap. offered by the latter, not only relative to emerging equities but also relative to
other speculative-grade fixed income asset classes (such as US high yield).
• Finally, emerging equities performed very strongly in the early 1990s; and in
many respects, the rest of the decade represented a hangover from this earlier
time of prosperity.
Our sense is that at least some of these historic reasons for the
underperformance of emerging equity over the past decade are changing. For
example, ML’s view is that the dollar is likely to continue to depreciate not just
against the Euro and the Yen, but also against certain emerging market currencies.
In countries such as Poland and Korea, ML’s economists think we could be
looking at up to 20% upside versus the dollar. And the current account surpluses
and mushrooming FX reserves that argue for undervalued emerging market
currencies also suggest a more stable macro backdrop than in the past decade, with
scope also for domestic demand to become a more dominant driver of growth.

2 Refer to important disclosures on page 7.

 Global Emerging Markets – 8 January 2004

As we move into another year of global financial-asset reflation, playing the

Chart 2:
global recovery story and favouring down-in-quality strategies (at least in the early
Emerging Equities-vs.-World Equities
part of 2004), emerging equities – and to some extent, emerging corporate and
.00
local-currency debt – fit these investment themes quite neatly (less so emerging
.90 sovereign debt).
.80 Again, then, we reach the conclusion that the neglected, under-invested asset,
.70
namely emerging market equity, looks more compelling than the more highly
regarded, less attractively valued asset, namely emerging market sovereign debt.
.60

.50
#2 Emerging Equity More Attractive Than Global Equity
.40

As Chart 2 shows, emerging market equities have gradually outperformed global

.30
equities over the last five years, although only part of the damage done between
.20
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
1994-98 has been reversed.
MSCI EMF-VS-MSCI WORLD

Looking out to 2004, we continue to argue for overweighting emerging market

Source: Datastream equities in a global equity portfolio. Above all, we believe emerging market
equities still look pretty cheap. The MSCI EMF index is trading on a rolling
12-month forward P/E ratio of 11x. As Chart 3 shows, this is still well toward the
bottom end of the historic range, which has tended to be 8-20x earnings.

Chart 3: Emerging Equity and Global Equity 12M Forward P/E Ratios

2 6

2 4

2 2

2 0

1 8

1 6

1 4

1 2

1 0

8
9 0 9 1 9 2 9 3 9 4 9 5 9 6 9 7 9 8 9 9 0 0 0 1 0 2 0 3
E M E R G IN G M A R K E T S 1 2 M F O R W A R D P /E
G L O B A L 1 2 M F O R W A R D P /E

Source: Datastream

In addition, emerging equities look cheap when compared with global

equities, which are trading on roughly 17x earnings. In other words, the
emerging markets discount is roughly 35%.
Emerging equities trade at a The question obviously arises as to the appropriate emerging markets
35% discount to global equities. discount. Unfortunately, there is no precise way to answer this. If we utilise
the Gordon growth model, we know that a “fair value” P/E ratio is a function
of dividend payout ratio, cost of equity, and the (somewhat unmeasurable)
long-term growth assumption. Emerging markets have tended to have lower
payout rates (roughly 35%, vs. 45% for global equities), and a higher cost of
equity; two good reasons for a discount. Equally, however, when we look at
the first half of the 1990s, we see that emerging markets traded on the same
multiple as global equities, before a significant discount opened up in the
second half of the decade. We think this tells us that subjective long-term
growth expectations in emerging markets were, in the early 1990s, considered
markedly superior to expectations in developed markets, offsetting the other
possible justifications for a discount. But in the second half of the decade, as
technology buoyed global markets and emerging markets suffered macro
instability (Mexico 1994, Asia 1997, Russia 1998, Brazil 1999), long-term
growth expectations for the asset class declined significantly.

Refer to important disclosures on page 7. 3

Global Emerging Markets – 8 January 2004

Improving long-term growth Our view: subjective long-term growth expectations are now starting to
expectations in emerging rise – and will continue to rise − in emerging markets, relative to
markets should allow this expectations for developed markets, in a manner that can allow the
emerging market discount to close. Investors are increasingly upgrading
discount to narrow.
their average real GDP-growth expectations for emerging economies, we
believe, as they factor in the benefits of strong balance-of-payments positions,
whilst also recognising an improving ROE performance at the corporate level.
What we don’t know, however, is how far this process is likely to go – at the
limit, it is not inconceivable that emerging markets might once again trade on
global P/E multiples. For now, however, we think the existing discount is still
too high – particularly given how far the emerging markets cost of equity has
fallen of late – and we argue for a secular overweight in emerging markets.

#3 What We Like in Emerging Equity

What we particularly like within the emerging equity universe can be summarised
into two separate categories, namely (a) cyclical plays and (b) beneficiaries of
dollar weakness.

n Cyclical Plays
Chart 4: Emerging Equities and YoY
Chart 4 shows that, for over ten years, there has been a strikingly close association
Change in G7 Leading Indicator
between the level of the MSCI EMF index and the year-on-year change in the
600 10 OECD’s G7 leading indicator. What this tells us is that emerging equities have
550 8
traded essentially as warrants on global growth expectations. Periods in which
such expectations have been declining, such as in 2000 or late 2002, have often
500 6 seen weakness in emerging equities. Conversely, periods in which global growth
450 4
expectations have been rising, as has been the case since spring 2003, have tended
to see strong performance from emerging equities.
400 2
Although the year-on-year change in the leading indicator is already toward the
350 0 stronger end of its historic range, 2004 will seemingly start with an encouraging
300 -2
global outlook. The upturn in US business sentiment has filtered through to
Euroland and Japan. And, after a period of destocking this year, there would seem
250
91 92 93 94 95 96 97 98 99 00 01 02 03
-4 scope for something of an inventory rebuild over the next few months. It is hard to
MSCI EMF U$ - PRICE INDEX
YOY CHANGE IN OECD G7 LEADING INDICATOR (R.H.SCALE) see why global industrial output growth should not pick up strongly in early 2004.
Source: Datastream This outlook presents an interesting opportunity in the more cyclical emerging
markets, namely Korea and Taiwan, because both these markets lagged the
benchmark in late 2003. Korea struggled in the wake of a weak consumer
backdrop, the hangover of an earlier credit card boom. But note that consumer
confidence has picked up in the last two months, and we think this market, the
biggest in the emerging markets universe, would benefit from a strong 1Q for the
asset class. Meanwhile, Taiwan has been held back by politics, as President Chen,
facing re-election, has upped his rhetoric vis-à-vis China. While this issue remains
a near-term risk, there are a number of stocks in Taiwan – both tech and non-tech –
with decent valuations and solid earnings momentum.
Catch-up potential in cyclical So we think it is worth starting 2004 with overweight positions on both Korea
Korea and Taiwan and Taiwan. That said, this position will need to be re-assessed as and when the
year-on-year change in the G7 leading indicator starts to roll over, since this has
traditionally been a signal to lighten up on these cyclical markets.

n Beneficiaries of Dollar Weakness

One of ML’s key calls for 2004 is the continuation of the dollar bear market. Our
first point is that we think this is generally positive for emerging markets; recall
that in past, in phases of secular dollar weakness (such as the late 1970s and the
late 1980s), emerging markets have generally prospered. But, within emerging
markets, two particular types of investment should particularly benefit:

4 Refer to important disclosures on page 7.


India and Thailand are our
favourite reflation trades.
Brazil and Turkey are our
favourite disinflation trades.
Rising interest rates and a
modest widening in spreads
imply zero returns on emerging
sovereign debt in 2004.
Global Emerging Markets – 8 January 2004
• Reflation Trades. If the US is to rectify its current account deficit problem
through dollar depreciation, economies running current account surpluses will
need to reduce the size of those surpluses. This can occur either through
currency appreciation, or – as central banks initially resist such appreciation –
through strong domestic liquidity growth, asset price reflation, and a more
vigorous pace of domestic demand growth. We think that a number of
emerging economies belong in this category, including India, China,
Thailand, Malaysia, and Russia.
The global outsourcing phenomenon has transformed India’s current account
position, bolstering FX reserves and pushing interest rates lower. We like
Indian banks, construction plays and consumer names. Thailand has, thus
far, most eagerly embraced the opportunity offered by a current account
surplus to stimulate growth. ML is looking for 5.5% growth in 2004, after
5.7% growth this year. We continue to favour Thai construction-related
stocks and telecoms.
Also potentially benefiting from reflation is Malaysia, the country with the
largest current account surplus (as a share of GDP) in emerging markets. It is a
bit harder to find stock ideas in this market, however. And Chinese stocks have
already performed very strongly this year, and are arguably due a pause. Finally,
the macro backdrop in Russia remains extremely benevolent for asset prices,
once the current environment of political/corporate uncertainty starts to fade.
• Disinflation trades. This category includes countries that have historically
experienced relatively high inflation, and have thus tended to have weak
currencies but high nominal interest rates. The onset of the dollar bear market,
combined with low interest rates in the developed world, has encouraged
investors to migrate to high-yielding currencies such as the Turkish lira,
Indonesian rupiah, Brazilian real, or South African rand. The unusual currency
strength has squeezed inflation out of these countries and pushed down interest
rates, in turn encouraging credit upturns and stronger domestic demand.
We remain positive on Turkey and Brazil for this reason, particularly
highlighting financials and consumer plays. In South Africa, however, our
enthusiasm for domestic-oriented stocks (banks, telecoms) is countered by
caution on the resource stocks, which are seeing their margins squeezed by
the strength of the rand.
#4 What We Like in Emerging Debt
It is no surprise that 2004 is likely to be a more challenging year relative to 2003 for
emerging sovereign debt. We expect the latter to post a zero return in 2004, but the
risks to this forecast are poised to the downside. Our base case (to which we attach
a two-thirds probability) calls for a modest widening in emerging markets spreads
of 50 basis points. When overlaying the Merrill Lynch forecasted back-up in the
US risk-free curve (125 basis points on the UST 10-year bond), and adding a
flattening bias to the shift in the Treasury curve, we arrive at that flat return for the
year. The chart below shows the matrix of returns for various combinations of
Treasury and emerging market spread movements (but does not account for shifts
in the Treasury curve, hence the slightly better return in our forecast).
Refer to important disclosures on page 7. 5
 Global Emerging Markets – 8 January 2004

Table 1: Estimated EM IGOV Index Return Approximations for 2004(%)

UST Change (bps)
Spread
Change 0 25 50 75 100 125 150 175 200
(bps)
-100 12.9 11.4 10.0 8.6 7.2 5.7 4.3 2.9 1.5
-75 11.5 10.0 8.6 7.2 5.8 4.3 2.9 1.5 0.1
-50 10.0 8.6 7.2 5.8 4.3 2.9 1.5 0.1 -1.4
-25 8.6 7.2 5.8 4.3 2.9 1.5 0.1 -1.4 -2.8
0 7.2 5.8 4.4 2.9 1.5 0.1 -1.4 -2.8 -4.2
25 5.8 4.4 2.9 1.5 0.1 -1.3 -2.8 -4.2 -5.6
50 4.4 2.9 1.5 0.1 -1.3 -2.8 -4.2 -5.6 -7.0
75 2.9 1.5 0.1 -1.3 -2.8 -4.2 -5.6 -7.0 -8.5
100 1.5 0.1 -1.3 -2.7 -4.2 -5.6 -7.0 -8.4 -9.9
125 0.1 -1.3 -2.7 -4.2 -5.6 -7.0 -8.4 -9.9 -11.3
150 -1.3 -2.7 -4.2 -5.6 -7.0 -8.4 -9.9 -11.3 -12.7
175 -2.7 -4.1 -5.6 -7.0 -8.4 -9.8 -11.3 -12.7 -14.1
Source: Merrill Lynch, Note: Based on Treasury and Spread durations of the index as a whole (parallel shift in Treasury and
spread curves in all bonds and across the curve).

In terms of strategy, we stay with the global asset reflation theme. Given
current valuations in credit markets, asset reflation in 2004 implies a world where
there is a higher likelihood that bonds will come under pressure, and a new stage
Table 2: 2004 Debt Service on
in the cycle: one where spread-product performance begins to more decidedly lag
EM Sovereign Bonds, US$bns
that of equities. The down-in-credit theme remains largely operative, at least
Month Principal Interest Total for the first few months of the year, in essence a continuation of 2003.
Jan 1.4 2.9 4.2
Feb 3.2 2.5 5.7 High-grade emerging debt is likely to underperform high-yield emerging debt
Mar 5.6 3.1 8.7 in 2004, unless there is a risk aversion shock that causes Treasuries to rally. For
Apr 3.9 2.4 6.3 emerging debt, the principal drivers going into the early months of next year are:
May 0.4 1.4 1.8 (i) financial markets awash in liquidity, (ii) the related robust technical position of
Jun 1.9 1.7 3.7 all financial markets (with sizable amounts of moneys still parked in US money
Jul 2.0 2.8 4.8 market funds), and (iii) strong risk appetites. The biggest challenge will be getting
Aug 0.6 1.6 2.2 the timing of a turn in Fed policy correctly. For markets, it is the development of
Sep 2.9 2.4 5.3 expectations of a change in policy that matter most, less the actual policy action.
Oct 2.2 2.5 4.7
Nov 0.6 1.2 1.8
As in the past year, strong technicals – a function of ample global liquidity –
Dec 1.4 1.5 2.9
will continue to play an important role, not just for emerging debt but for
Total 26.0 25.9 51.9
financial markets as a whole. Related to this are the sizeable debt-servicing
% of Face 7.6% 7.7% 15.3% payments on EM sovereign bonds that come due in the early spring (March and
April, in particular), as shown in Table 2 below.
Note: If the stock of debt issued is less than 15% of the
current stock, and assuming investors retain market cap, Commodity prices are likely to remain strong and dollar weakness will likely
demand will exceed supply.
Source: Merrill Lynch persist. The latter is likely to be successful in redistributing global growth, with
Asia being the largest beneficiary. Emerging countries that represent plays on
commodities and/or the global recovery are likely to be good bets.
We like Venezuelan, Uruguayan Within the external debt universe, we expect Venezuela, Uruguay, and the
and Philippine external debt, as Philippines to outperform. We also expect Brazil, Russia, and Colombia to do
well as TRL-, PLN-, and ZAR- well in early part of 2004. Non-US$ hard currency bonds and selected local
currency plays offer more upside potential than plain vanilla US$-
denominated local debt. denominated sovereign bonds. For dollar-based investors, EUR- and JPY-
denominated bonds in the higher-beta countries offer opportunities for off-index
outperformance potential. So long as the down-in-credit theme remains viable,
corporates in several EM countries may also offer interesting upside potential. On
the local-currency debt front, we like Turkish Treasury bills, PLN-
denominated government bonds, and South African local currency bonds
(during H1).

6 Refer to important disclosures on page 7.

 Global Emerging Markets – 8 January 2004

Important Disclosures
Investment Rating Distribution: Global Group (as of 31 December 2003)
Coverage Universe Count Percent Inv. Banking Relationships* Count Percent
Buy 1050 42.53% Buy 352 33.52%
Neutral 1236 50.06% Neutral 309 25.00%
Sell 183 7.41% Sell 31 16.94%
* Companies in respect of which MLPF&S or an affiliate has received compensation for investment banking services within the past 12 months.

OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK RATINGS, indicators of potential
price fluctuation, are: A - Low, B - Medium, and C - High. INVESTMENT RATINGS, indicators of expected total return (price appreciation plus yield) within the 12-
month period from the date of the initial rating, are: 1 - Buy (10% or more for Low and Medium Volatility Risk Securities - 20% or more for High Volatility Risk
securities); 2 - Neutral (0-10% for Low and Medium Volatility Risk securities - 0-20% for High Volatility Risk securities); 3 - Sell (negative return); and 6 - No
Rating. INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend considered to be secure); 8 - same/lower (dividend not
considered to be secure); and 9 - pays no cash dividend.
Additional information pursuant to Section 34b of the German Securities Trading Act: Merrill Lynch and/or its affiliates was an underwriter in an offering of
securities of the issuer in the last five years: Colombia; Philippines; South Africa; Uruguay.
The analyst(s) responsible for covering the securities in this report receive compensation based upon, among other factors, the overall profitability of Merrill
Lynch, including profits derived from investment banking revenues.

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Refer to important disclosures on page 7. 7