Our quantitative country model leads us to make the following changes to our country allocation:

Downgrades: Brazil to underweight from equal weight; South Africa to UW from EW; Poland to EW from OW; Turkey to EW from OW.

Upgrades: Chile to OW from EW; Hungary to OW from EW; Egypt to EW from UW; Philippines to EW from UW.

The model's ranking of Brazil has fallen from #12 to #17 this month due mainly to deteriorating relative valuation scores and rising currency risk (the latter feature shared with both South Africa and Turkey).

In our view the “virtuous circle” of exchange rate appreciation, commodity price strength, sovereign risk premium reduction, and equity valuation convergence has now run its course in Brazil. Forward P/E has essentially reached parity with the rest of EM and is also now well above the 5-year historically observed fit level to the sovereign spread. In absolute terms it has only been higher 10% of the time in the last 10 years.

Brazil's real effective exchange rate has doubled since the nadir of 2001/02. Our Latam economics team's expectation of a slower pace of interest rate declines, worse than consensus trade outlook, and downside risk to the currency implies a more difficult environment for the domestic demand sectors (banks, telecoms and retailers) in the Brazilian equity market next year.

It is time to be more selective, and we would choose to retain exposure to oils and mining. For Latam managers, we would recommend switching domestic demand exposure to Chile, while for BRIC managers we prefer exposure in Russia.

2007 has been marked by powerful macro trends and cross-currents. Many of the themes that dominated 2007 will likely be at least as relevant in 2008.

Our market calls for the past year: We were correct on the direction of the dollar, but we significantly underestimated its sell-off. While we anticipated this being another year marked by a cyclical dollar descent, with the US economy being singled out as the only soft spot in the world, we attached a remote possibility to EUR/USD getting anywhere near 1.50. This was because we underestimated the power of central bank diversification and how quickly the world would lose confidence in the dollar. We were consistently positive on EM currencies in general and the AXJ currencies in particular, which was a good call.

Some of our qualitative calls are noteworthy. We were very positive on the global economy, and consistently argued that risky assets (mainly equities) would rise enthusiastically but fall grudgingly. We were among the first to highlight the importance of sovereign wealth funds (SWFs). We also placed considerable emphasis on the declining home bias in many EM economies.

Key lessons for 2008: We identify four key lessons that matter for the currency markets for 2008. (1) This is more than a subprime crisis. It will take time for banks to sort out their balance sheet problems. (2) Central banks are potent, and the Fed's willingness to deal with the liquidity issue should not be questioned. However, whether the interbank money market dislocations can be fully resolved will be a function of how banks' confidence may be altered by the Fed's action. (3) The fruits of globalisation have been exceedingly evident this year. Not long ago, EM decoupling from the US was unthinkable. (4) The rise of SWFs is genuine, and we are at the beginning of a long-term process.

Last week's elevated inflation readings point to further near-term downside risk for the S&P 500 in general and financials in particular.

Those hoping that rapid and aggressive global monetary easing will offset growth and earnings deterioration may be forced to rethink assumptions regarding the timing and pace of policy response.

We are not suggesting that inflation readings will prevent the Fed from responding to growth concerns. Our base case remains for Fed funds to be 3.5% by mid-2008. However, the deterioration in asset quality, growth data and earnings estimates may be more rapid than the Fed's response.

In other words, the recent disappointment at a 25 bp rather than 50 bp cut that occurred in early December may well be repeated as the Fed takes an even more “measured” pace to rate cuts (potentially skipping cuts at some meetings next year). Similarly, ongoing elevated inflation readings in the Eurozone may reinforce the ECB's resolve to stay put, placing at risk hopes of concerted global easing.

For US financials, these inflation readings are especially negative as they potentially reduce the prospect of more rapid monetary easing, which is an almost consensus expectation, and, in our view, financials' strongest support.

At the current headline level (4.3% YoY), inflation is now running 1% above the long-term average. Based on our valuation model, this has the effect of reducing the fair value P/E by 1 point. Assuming flat reported earnings growth in 2008 (and this may well prove optimistic), this points to downside for the S&P 500 at 1350 ($83 reported earnings and 16.3x P/E). Clearly, not an outcome widely anticipated.

China a potential buyer of Japanese stocks: The China Investment Corporation (CIC) is a potential buyer of almost Y1 trillion in Japanese stock. If it is able to hire the right investment personnel, such purchasing could start in six months to a year. Initially, we think the CIC will likely purchase broadly, in index baskets rather than in certain sectors.

Japanese equity strategists in Beijing: The November 26 Nikkei Shimbun (evening edition) reported that the Chinese government in effect will begin investing assets in Japanese stocks, based on recent recruitment ads for strategists at the CIC website. On November 29, the CIC partially outlined its current investment strategy. You, too, could become a Japan equity strategist, in Beijing.

Long-term investment strategy too: While the CIC will seek risk dispersal for falling US dollar asset values, its investments will also be strategically aimed at yen-denominated assets, so as to acquire the right assets and technology for sustainable growth of the Chinese economy. This could take 3-5 years.

While the current US-led credit market turmoil should theoretically have limited impact on the Asian corporate sector, the blowout in credit spreads could easily lead highly leveraged stocks to underperform. With high dependence on bond funding and an elevated bank loan-deposit ratio, Korea appears vulnerable, as do select stocks elsewhere.

Despite sharp increases in credit spreads, Asia's highly leveraged stocks have not yet materially underperformed.

The AxJ iTraxx Index Has Blown Out By 100 bp. The iTraxx index for Asia ex-Japan has risen sharply since July, tracking the rise of global credit spreads. This has occurred despite Asia's strong fundamentals. First, Asian balance sheet leverage is at a record low 33.7%, about half the level of a decade ago. Second, bond issues constitute a relatively small part of Asian corporate finance, with total private-sector bond issuance reaching US$49 billion in 2006 (vs. loan growth of US$842 bn and equity issuance of US$156 bn). Third, the banking system is very liquid, with the loan-to-deposit ratio at a near-record low 73%.

Korea appears vulnerable. While Korean corporates have deleveraged substantially over the past decade (from 335% in 1997 to 37% in 2006), the relatively high dependence on bond funding (US$39 bn YTD vs. equity issuance of US$6 bn) and an elevated loan to deposit ratio (136%) appear to expose Korea companies to current credit market turmoil. Indeed, the Bank of Korea injected liquidity via the bond market late last month to curb surging short rates and alleviate a funding squeeze.

Avoid High Leveraged Companies. During bull markets, highly geared companies tend to outperform. However, with current credit market turmoil, highly geared stocks may suffer from funding constraints, limiting their growth potential and reversing their outperformance. For example, select highly leveraged Chinese property developers have corrected sharply on the back of failed bond issues.

External environment likely to deteriorate in 2008: The risk of credit problems attacking the heart of US growth - household consumption - has increased significantly. Morgan Stanley's US Economics team now expects a mild recession in 2008.

Limited recoupling in 2008: We estimate that AXJ growth will slow significantly, to about 7% in 2H08 from 9% YoY in 3Q07, but this would be significantly less severe than in the 2001 recession.

AXJ better placed to face US recession: The macro balance sheet is much less vulnerable to external shocks in the current cycle than was the case in 2001. Domestic demand dynamics are also much better in the current cycle.

Downside risk: Significant turbulence in the US equity markets could spread to Asian financial markets.

We are neutral Australian equities and think risks are to the downside. We think earnings growth will remain positive, but a US recession could worsen what is already a declining trend. We think 2009 consensus earnings growth of 11.7% is more at risk (particularly the 17.6% forecast for metals & mining). Importantly, domestic multiples remain at stretched levels, and we think a multiple de-rating is required to price in what are now substantial global risks. Finally, correlation to US markets means we would not avoid the ramifications of a US bear market or a fall in investor risk appetite.

Recession in the US and a global growth slowdown: Our US economics team expects a mild US recession in 2008. We are already seeing an earnings recession in the US, and our European team expects negative earnings growth as well. Whilst EM and Asia/Pacific growth should remain positive, it may slow due to a combined US and EU decline.

Our index target: Our S&P/ASX 200 target of 6,693 is a probability weighted target of our Bull Case (7,639, 20% probability), Base Case (6,761, 50% probability), and Bear Case (5,949, 30% probability). This implies that the Australian equity market ends the year broadly flat.

A defensive strategy: We seek non-cyclical, defensive sectors at this stage. Our sector preferences are banks, healthcare, food & beverages, infrastructure, and utilities. We like dividend yield, and also think stable growth should continue to outperform contrarian value as conditions deteriorate. Critical to this will be timing any recovery, for value and cyclical stocks should then sharply outperform. See our full note for ten stocks that our analysts recommend and meet our defensive criteria.

2007 was the fourth successive bumper year for market intermediaries, i.e., brokerages, mutual funds and investment banks and market participants. Equity investors had a superb year, especially in the second half, with returns improving down the cap curve in the last quarter and volatility rising only marginally.

Trading volumes jumped a whopping 65% y/y and the dollar value of trading has more than quadrupled in four years, thanks in part to the big increase in share prices. Institutional trading volumes rose more than 80% y/y, with their share in total trading rising by 3 pp to 26%. Equity issuance rose 30% in 2007 and M&A volumes almost doubled y/y. Fixed income funds experienced a big surge in flows although equity flows fell about 25%. Assets under management reached record levels across the board and have quadrupled in four years.

Indian equities produced another stellar year with absolute and relative gains. India is currently on course to finish the year as the third-best EM. Mid- and small-caps regained their edge over large caps, though the bulk of this has happened in the closing stages of the year. India's relative gains versus EM have also been concentrated in the last quarter. Nine out of the 10 MSCI sectors produced positive returns. The best in class were utilities, energy and industrials, whereas the worst sectors were technology, discretionary and healthcare.

Net earnings for MS coverage universe was up 38%, a distinct improvement from 2006. Earnings were helped by margin expansion and strong net financial income. Earnings revisions stayed strong as in the previous three years, with the F2009 consensus EPS estimate for the BSE Sensex constituents rising about 10% from the start of 2007.

The bulk of India's outperformance over EM was explained by an increase in the relative multiple for India. The relative multiple was up 20% through the year. The biggest sector level re-rating took place in telecoms, utilities and energy. Technology, healthcare and consumer discretionary suffered de-rating.

Global equity markets have climbed a long way from their 2002/03 lows, consistently stepping up from the 'bigger picture' support areas according to our analysis. We believe that medium-term upside objectives in the regionally representative equity indices - namely S&P 500 at 1700, 1725 (NDX 2400, 2600 etc); TWSE 10,600, 11,300; Nikkei 225 at 20,300; SX5E at 4700, 5300 - remain well within the realms of reality. However, although the bigger-picture uptrend remains intact, it is not in force at the moment according to our analysis.

The Wall of Worry with which equity markets have had to contend for most of their upward journey continues to hold firm. Fundamental concerns about US growth prospects, which have been consistently reflected in bond, dollar and sectoral weaknesses e.g., Banks, Housebuilders) since the middle of 2006, can easily spill over into fears of a broader, more global growth shortfall. More recently and specifically, given the importance of liquidity in any market equation, the fact that short-term US bank deposit rates have reached their widest differential over US Government Treasury Bill rates since 1987 (and in ratio terms are far wider) is indicative of the marked illiquidity threat to markets.

Focusing on the shorter-term situation, we note that at the end of November, the S&P 500 (our global equity market proxy) rallied powerfully from the area we defined as support for a "surprise" rally around 1400. However, since then prices have reached and reacted from the nearest relevant resistance region at 1520/30 (in conjunction with the Nasdaq 100 falling from the equivalent barrier around 2150), which we defined as the "risk reduction" zone. Also, we observe that both the Russell 2000 (a reasonable guide to both liquidity and US domestic growth conditions) and the Nasdaq 100 (our global technology/psychology indicator) continue to underperform the broader market. As long as the aforementioned barrier (SPX at 1520/30, etc.) holds firm (or we see a combination across the asset classes suggestive of stability), we will remain in a heightened risk environment and therefore continue to be "suspicious of strength".

We realise that in the current heightened risk environment, we may well witness another attempt to pull the S&P 500 through the psychological support in the 1400 area all the way down towards the 1310/00 area (equivalent to Nasdaq 100 at 1800/1780, Russell 2000 at 650, Eurostoxx 50 at 3800/3750, Nikkei 225 at 13,500/400, etc.) before the uptrend can continue.

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The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Jonathan Garner, Abhijit Chakrabortti, Naoki Kamiyama, Malcolm Wood, Ridham Desai, Paul Ruddleston.

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(as of November 30, 2007)
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More volatile (V). We estimate that this stock has more than a 25% chance of a price move (up or down) of more than 25% in a month, based on a quantitative assessment of historical data, or in the analyst's view, it is likely to become materially more volatile over the next 1-12 months compared with the past three years. Stocks with less than one year of trading history are automatically rated as more volatile (unless otherwise noted). We note that securities that we do not currently consider "more volatile" can still perform in that manner.

Unless otherwise specified, the time frame for price targets included in this report is 12 to 18 months.

Analyst Industry Views
Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below.
In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below.
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Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index.

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