UBS: 2017 Outlook: Nervously Positive; ROEs are Key

2017 Outlook: +4-5%

Our end-year MSCI GEMs target is 900, but with upside risk. The UBS global macro base case for 2017 is fairly benign for EM: i) a modest pick-up in global growth; ii) the Chinese economy resumes a 'soft landing' trajectory; iii) two Fed rate hikes; iv) US 10-year yields drift back to 2.25%; v) the USD falls v. the Euro and Yen, with small gains against EM currencies; vi) Brent oil prices rise to an average of $60.

Can Higher ROEs Boost EPS in 2017 – and Allow Outperformance of DM?

Our top-down forecast for EM EPS growth is 6% ($) after 8-9% in 2016. The keyupside risk to such modest growth comes from an extension of last year's tentative rebound in ROEs (as margins rose and capex was subdued) leading to higher operating leverage, with or without a rebound in revenue growth. EM enters 2017 at 11.9x forward (above its recent average of 10.9x). The valuation case for EM is relative to DM. If EPS and ROEs surprise, EM's P/BV discount to DM of 32% (v. an average of -13%) – with EM ROEs above DM and rising higher – should support EM equities v. DM.

Upside and Downside Scenarios: A Wide Array of Risks

The danger for 2017 is the wide array of possible scenarios around our base case, with manifest risks in both directions: i) Upside (EM: +25%): i) strong global growth, without rising inflation; ii) falling US yields, little Fed; iii) falling USD; iv) rising EM ROEs; v) increased flows and weightings in EM. Downside (-11%): i) sharp rise in global inflation; ii) major slowdown in China, with a steep fall in CNY; iii) sharply higher US yields; active Fed; iv) further outsized USD gains; v) further political shocks in DM.

Strategy: Upgrade LatAm to Neutral, Financials, Energy to O/W

After lagging badly in 2016, Asia is an O/W going into 2017; we upgrade LatAm toNeutral and cut EMEA to U/W. We stay O/W in Russia, India, Korea, Taiwan, Hungary and Peru; we lift Colombia to O/W (oil prices) and cut Turkey to U/W. The 'carry' should still help Brazil and we upgrade to Neutral; China is a Neutral; Mexico and SA are U/Ws. We move O/W in Financials (improving fundamentals, steeper curves) and Energy (oil price upside) and cut IT, Consumer Discretionary and Health Care to Neutral. Our Top 40 EM Stock List includes: Petrochina, Shenhua Energy, CCB, Tencent, Hyundai Mobis, Hon Hai Precision, TSMC, SBI, HDFC, Petrobras, Itau Unibanco, Sberbank, Naspers.

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