Riding a new wave Emerging markets: The new normal

Transcription

1 UBS Asset Management September 2016 by the Emerging Markets and Asian Equities Team headed by Geoffrey Wong For professional client/ institutional investors only Riding a new wave Emerging markets: The new normal

2 Contents Riding a new wave 05 Chapter 1 Emerging markets: The new normal 13 Chapter 2 The rise of the emerging market consumer 19 Chapter 3 Healthcare: Growing demand and innovation 25 Chapter 4 Information Technology: Global and domestic opportunities 31 Chapter 5 Financials: Bank value drivers in the new normal 37 Chapter 6 Commodities: How to profit in a subdued oil price world? 45 Chapter 7 Real Estate: Rising income, urbanization to lift Asian countries 51 Chapter 8 The threat of globalization is reversing 2 Riding a new wave Emerging Markets: The new normal

3 In the slow-growth 'new normal,' markets will seek investment themes that are not overly dependent on global economic growth. A meaningful proportion of these secular themes can be found in the Emerging Markets. Riding a new wave Emerging Markets: The new normal 3

4 4 Riding a new wave Emerging Markets: The new normal

5 Chapter 1 Emerging markets: The new normal Riding a new wave Emerging Markets: The new normal 5

6 Emerging markets: The new normal There has been increasing discussion of the world being in a 'New Normal' of low economic growth with persistent low inflation. The tepid economic recovery from the global financial crisis of is evidence of this New Normal. Low long-term bond yields and a flat yield curve bears evidence that the markets believe in the New Normal as its base case. Demographics would lend further support to tepid future long term growth. Global working- age population growth for the period was 1.75% annually. For the next 50 years, working age population growth is expected to be only 0.71% annually, over a percentage point lower, according to The World Bank. All else being equal, this translates to a roughly 1% loss in potential gross domestic product (GDP) growth. If this outlook is correct, then the markets will continue to seek and place value on investment themes that are not overly dependent on global economic growth. A meaningful proportion of these secular themes can be found in the emerging markets. Through our research, we have identified the most investable markets and sectors over the next few years. In this introduction, we look briefly at countries; and many opportunities are in emerging market (EM) countries. Overall GDP growth alone often does not translate into improved equity market returns, so we must look at corporate performance and secular investment themes that are attractive despite a low global growth environment. We incorporated our proprietary research on corporate quality to arrive at our conclusions. For active stock pickers, in addition to high potential GDP growth and good cap-weighted corporate quality scores, it is also important that the markets have a large number of high-quality large-cap companies. In the rest of this paper, our investment team, structured along sector lines, offers a more in-depth view of the most promising business sectors. Countries poised for growth Countries with inherent growth drivers will likely have an edge as profitable investments. In order to help us identify these countries, we draw on research on the drivers of economic growth and apply these to the current environment. In particular: 1. Robert Barro of Harvard University, whose work in economic growth is among the most cited empirical work on the topic. 1 In a study of 98 countries over the period , Barro's model identifies the following factors as significant growth drivers of per capita GDP growth (per capita GDP divides the monetary value of all goods and services produced over a specific time in a country by the number of that country's residents): The starting level of per capita GDP: Lower per capita GDP provides more scope for catch-up growth in the future. Education: The higher the proportion of population with primary and secondary school education, the higher is subsequent economic growth. Exhibit 1. Working age population growth is slowing, which leads to a rising dependency ratio (Japan's sharp rise shown here for comparison) 80% Dependency Ratio Ratio of <15 & >=65 to years old 70% 60% 1.75% Working Age Population Growth 50% 40% 0.71% Working Age Population Growth 30% World Japan Sources: World Bank, US Census Bureau, JPM, UBS AM. 6 Riding a new wave Emerging Markets: The new normal

7 Emerging markets: The new normal Government consumption as a percent of GDP. Lower government consumption was associated with faster per capita GDP growth. While controversial to some, this variable had strong statistical significance with a t-statistic of -4. Political stability, measured by the number of revolutions and coups per year, and the number of assassinations per million people per year. 2. David Bloom of Harvard, whose work focused on the growth of the working age population, rather than growth in total population Antonio Fatas and Ilian Mihov of INSEAD identified "4 I's" of economic growth: 3 Innovation Initial conditions, same as in Barro's work above. Investment, as measured by investment to GDP ratios. Institutional quality, which we proxy by the World Banks Ease of Doing Business Index The above work sought to explain past GDP growth using the above variables at the start of the time period of study. In this paper we use the current values of the above variables (where available) to predict countries most likely to produce high GDP growth over the next five to 10 years. Of the above variables, we omit the Revolutions per Year and Assassinations variables, as in Barro's work these variables were concurrent with the time period and it would be difficult or impossible to forecast revolutions and assassinations going forward. In any case, these factors are likely most relevant in the least developed countries, which may be less investable for public markets investors. We substitute average years of schooling for Primary and Secondary education rates as this variable is available across countries on a timelier basis. Fatas and Mihov did not suggest an indicator for Innovation, and hence that is omitted. Overall, in Barro's work, the variables explained 50%-60% of cross-sectional GDP growth variation between countries. Hence there are other factors, some of which will be country specific. Importantly, the ability of the country to improve on factors such as ease of doing business and education will significantly impact its prospects. Relevant to investors, a country's listed companies may 'outperform' its economy or vice versa, depending on the quality of management. We will discuss these issues in this paper. Developing a robust country-ranking framework Using various data sources, the UBS Emerging Markets team ranked 57 developed- and emerging-market countries across six key factors identified by the research: growth in working age population from ; average years of education; World Bank Group's Ease of Doing Business rank out of 189 countries, per capita GDP in 2014 and purchasing power parity (PPP) in 2011 USD, investment as a percentage of GDP and government consumption expressed as a percentage of GDP. We then used the factor rankings to develop composite country rankings. As Exhibit 2 shows, overall, EM countries come out ahead of developed markets (DM) in terms of potential GDP growth. However, the weighted average advantage, weighed by PPP GDP, amounts to only about half a quintile in ranking. EM countries will produce a 4.2% growth in working age population in the next five years, whereas DM countries will shrink by -0.2%. Beyond demographics, EM countries have an advantage in catch-up potential, greater investment as a percent of GDP and lower government consumption. The differences between EM countries are as great as the differences between EM and DM; hence, while investing in EM as a whole is part way toward addressing the question of where to invest in the New Normal, differentiating between individual countries can yield better returns. From a regional perspective, Asia comes out well, driven by good demographics in most countries (with the notable exception of China), a smaller government sector and high levels of investment. This is much as most investors might expect. What stands out is that Asia's high ranking is not driven by India and China, but more by the Association of Southeast Asian Nations (ASEAN) members: Malaysia, Indonesia, Philippines and Singapore. These exhibit good demographics, investment and low government spending. India is penalized in the rankings by low education and ease of doing business scores. China is penalized for poor demographics and somewhat low education and ease of doing business scores. Riding a new wave Emerging Markets: The new normal 7

8 Emerging markets: The new normal Exhibit 2. Ranking countries by developed-market and emerging-market regions Growth in working age population Average years of education World Bank Ease of Doing Business Rank out of 189 countries Per Capita GDP in 2014 Investment as a percent of GDP Government consumption as percent of GDP in % Rank Years Rank Rank Rank PPP Rank % GDP Rank % GDP Rank Overall Rank 1=best Australia 3% , Singapore 4% , New Zealand 3% , Japan -4% , DM Asia Simple Average 1% , Switzerland 3% , Norway 3% , Germany -3% , United Kingdom 1% , Sweden 1% , Denmark 1% , France 0% , Austria 0% , Belgium -1% , Spain 0% , Portugal -2% , Greece -1% , Netherlands -1% , Italy -2% , DM Europe Simple Average 0% , Canada 1% , United States 1% , DM NA Simple Average 1% , Botswana 9% , Tanzania 18% , Nigeria 15% , South Africa 7% , EM Africa Simple Average 12% , Malaysia 7% , Indonesia 7% , Philippines 9% , Bangladesh 10% , Korea, Rep. -1% , Vietnam 2% , India 8% , Cambodia 8% , Azerbaijan -1% , China -1% , Pakistan 11% , Thailand -1% , Myanmar 7% , EM Asia Simple Average 5% , Riding a new wave Emerging Markets: The new normal

9 Emerging markets: The new normal Growth in working age population Average years of education World Bank Ease of Doing Business Rank out of 189 countries Per Capita GDP in 2014 Investment as a percent of GDP Government consumption as percent of GDP in % Rank Years Rank Rank Rank PPP Rank % GDP Rank % GDP Rank Overall Rank 1=best Czech Republic -3% , Hungary -4% , Poland -5% , Russian Federation -6% , EM Europe Simple Average -5% , Peru 7% , Mexico 8% , Bolivia 10% , Chile 4% , Colombia 5% , Venezuela 7% , Argentina 5% , Brazil 5% , EM Latam Simple Average 6% , United Arab Emirates 6% , Iran, Islamic Rep. 4% , Algeria 5% , Israel 6% , Turkey 6% , Saudi Arabia 10% , Kuwait 8% , EM ME Simple Average 6% , DM Weighted Average* EM Weighted Average* -0.2% , % , *Population, education and per capita income weighted by population, rest by GDP at PPP. Source: Robert J. Barro, pp ; David E. Bloom, David Canning, Jaypee Sevilla; Antonio Fatas and Ilian Mihov; World Bank; UBS Asset Management. Countries in Emerging Europe, the Middle East, Africa and Latin America show relatively less growth potential as the level of government consumption is too high and the overall investment level in the economies is too low. Like Asia, the Middle East, Africa and Latin America could improve their prospects by increasing education and ease of doing business, but we do not expect this to change quickly. The notable exceptions are countries in the Pacific Alliance, namely Mexico, Peru and Chile, which score relatively well, given favorable demographics, moderate-sized government consumption and good levels of investment. Emerging Europe has quite a different set of scores. Education scores are excellent and ease of doing business is good. However, the region is hampered by poor demographics, with negative working age population growth over the next five years. Riding a new wave Emerging Markets: The new normal 9

10 Emerging markets: The new normal Look beyond GDP growth for investment returns It has been noted that there is often a disconnect between GDP growth and equity returns. 4 While EPS growth and equity returns are strongly correlated, EPS growth often lags economy-wide corporate profits and GDP growth. This lag has been attributed to earnings dilution due to capital raising or new entrants. To identify investment opportunities along the country dimension, economic growth is not a sufficient condition: We also need to have companies in the country that will not dilute growth by continually raising capital. To do that, we use our proprietary research, which rates individual companies in EM along three measures of quality: 1. Industry structure and company competitiveness: Sample questions include 'how concentrated is the industry?' and 'what is the threat from changing regulation, technology and substitutes?' 2. Profitability, both current and expected over the medium-term future: Sample questions include 'what is the average historical ROIC or ROE?' and 'what is the expected trend of the structural ROIC/ROE?' 3. Corporate governance and disclosure: Sample questions include 'Is the company aligned to controlling shareholders or minority shareholders?' and 'is disclosure adequate for investors to understand the firm's profitability?' We rate companies from good to bad, quintiles 1 to 5 respectively, according to these measures. The ratings are based on primary research and management interviews with the companies. Approximately 30 qualitative and quantitative criteria are condensed into the above three measures to give the final quality score. Intuitively, companies that are profitable (able to generate their growth funding internally) and that have good corporate governance are less likely to dilute earnings. Conversely, an industry structure where there are many new entrants (e.g. the internet) is likely to produce EPS growth below that of overall industry earnings growth. We postulate that countries with both GDP growth and good quality companies are more likely to offer good investment opportunities. When we cap weight the company quality scores, we find that countries such as Indonesia, Hong Kong and the Philippines score well. China, Russia and India are dragged down on this measure by the significant representation of large State-Owned Enterprises which typically do poorly on our quality scores. These three markets also have a large number of high-quality companies, typically in the new economy. Outside of Asia, Hungary, Peru, Mexico and South Africa score well, but of those markets only Mexico and South Africa offer a large enough group of quality companies to invest in. A real positive is that in both South Africa and Mexico, the markets are made up mostly of companies that are privately owned, mostly in traditional sectors and banking. The cap-weighted quality scores are probably most relevant to a passive investor buying country ETF's. For an active investor doing stock picking, a more relevant measure may be the number of high quality large caps in the market. We define large caps as >USD 5 billion market cap, and high quality as being in the top two quintiles of quality within the company's sector. By this measure, China and India score well. While Indonesia is still attractive, there is a limit to the amount one can invest there, with just three large caps scoring well in our quality measures. 10 Riding a new wave Emerging Markets: The new normal

11 Emerging markets: The new normal Exhibit 3. Company Quality scores aggregated by country GDP growth potential Company Quality Scoring Quintiles all EM's Number of Country score Quality Large Quintile (cap wtd) Quintile Caps >$5bn Quintile Indonesia Peru Hungary Hong Kong Philippines Brazil South Africa Taiwan Singapore Mexico Czech Republic Thailand South Korea India Chile Russian Federation Malaysia China Poland Turkey Note: Combining the GDP growth scores with the company level scores, we find that the highlighted countries in the above exhibit stand out. This analysis indicates that Indonesia and the Philippines are attractive as country-level passive plays, with high GDP growth and good capweighted quality scores. For active stock pickers, India and China are the most interesting of this group, given their reasonable GDP growth potential and large number of high-quality large-cap companies. growth potential and high-quality companies. Other markets to monitor are South Africa and Brazil. Both are suffering from poor politics and as a result have low growth potential. But a shift for either could allow the large number of high-quality companies in either Brazil or South Africa to achieve good earnings growth. Outside of Asia, Mexico is the only investable market offering a healthy combination of Riding a new wave Emerging Markets: The new normal 11

12 Emerging markets: The new normal Sectors and Themes Having discussed opportunities on a macro level, we next turn to how we analyze opportunities on a bottom-up basis, looking across sectors and themes. Even in a slow economic environment, judicious selection of the right investment themes and business sectors can still deliver a decent return. Witness the performance of Toyota Motor Corp. (7203 JT) against the Tokyo Stock Exchange Index (TPXDDVD) over the 25 years since the Japanese economy peaked in While the Japanese market overall has had a negative return since 1989, Toyota has managed to deliver a decent total return in excess of global equities (MSCI TR Net World Index, NDDUWI). The company was exposed to positive industry trends such as a growing global population of drivers who were in the market for an economical and reliable car, especially as oil prices sky rocketed, and generally executed well over most of the period. Hence, well-positioned companies in poorly rated countries can still be good investments. Exhibit 4. Out-performance can occur even in long-term low-growth environments 600% 500% 400% Returns 300% 200% 100% 0% -100% Toyota Motor Corp Topix (JPY) Total Return Index MSCI World (USD) Daily TR Net Source: Bloomberg Finance, LP. 1 Robert J. Barro, "Economic Growth in a Cross Section of Countries," The Quarterly Journal of Economics, Vol. 106, No. 2, May 1991, pp David E. Bloom, David Canning, Jaypee Sevilla, Economic Growth and the Demographic Transition, Working Paper 8685, National Bureau of Economic Research. 3 Antonio Fatas and Ilian Mihov, The 4 I s of Economic Growth, INSEAD. 4 MSCI Barra Research, Is there a link between GDP growth and equity returns? Riding a new wave Emerging Markets: The new normal

13 Chapter 2 The rise of the Emerging Market consumer Riding a new wave Emerging Markets: The new normal 13

14 The rise of the Emerging Market consumer Among the structural drivers for growth in the Emerging Markets are: Rising income levels lifting over 400 million households from middle class to higher middle class; young, urban and tech-savvy consumers; decreasing dependency ratios (ratio of non-working to working population) in many markets. These factors support not only rising consumption, but are also changing consumption patterns. In this context, key themes are evolving and defining EM consumption trends: Rising wallet share for discretionary spending: Categories benefiting from this include leisure and entertainment, quick service restaurants, home improvement and travel. Premiumization and shift from unbranded towards branded products: Branded food and beverages (snacking products), apparel and footwear, liquor and personal care segments are key beneficiaries. Increasing focus on personal wellness and health: Healthcare services providers are benefiting. Rapid growth of on-line channels: Disruptive for traditional retail channels such as department stores and hypermarkets as well as for traditional media like print newspapers. Markets that possess attractive investment potential based on valuations, quality, liquidity and growth characteristics include India, China, Indonesia, Philippines, Russia and Brazil. India and Indonesia are seeing consumption recovering following a slowdown. Brazil is suffering from one of the worst recessions, but we believe consumption trends are close to bottoming out. Personal incomes in Russia have adjusted rapidly following the decline in oil prices, but recent consumption indicators have stabilized. In China, percentage of middle income households is expected to rise to 51% of total households by 2020, while in India these are expected to rise to 41%, according to UN figures. Other markets like Indonesia, Philippines, Brazil, Poland and Russia are also expected to see a sharp increase in middle income households. On the other hand, the picture on age profile and dependency ratios (ratio of non-working to working population) is mixed across various emerging markets. Notably, China and India are expected to see rising dependency ratios through 2020, while Argentina, Brazil, Indonesia, Mexico and Philippines are expected to see declining dependency ratios, according to the UN. Mexico, Indonesia, Turkey, Brazil, Argentina, Philippines and Malaysia all enjoy the following: 1. An increasing middle class population; 2. Increasing working age population, and; 3. Decreasing dependency ratio, (the ratio of Exhibit 5. Key consumer segments rated in relevant Emerging Market countries China India Indonesia Philippines South Korea Malaysia Thailand Russia Brazil Mexico South Africa Department Stores Negative Neutral Attractive Neutral Negative Negative Neutral Negative Apparel Retail Negative Neutral Neutral Negative Hyper/Supermarkets Negative Negative Neutral Negative Neutral Neutral Negative Negative Negative Food Discounters Attractive Home Improvement Neutral Attractive Attractive Attractive Cosmetics Attractive Attractive Negative Home and Personal Care Negative Neutral Neutral Neutral Healthcare Services Attractive Attractive Attractive Neutral Attractive Attractive Attractive Quick Service Restaurants Neutral Neutral Attractive Attractive Education Attractive Attractive Leisure/Entertainment Neutral Attractive Attractive Attractive Attractive Convenience Stores Attractive Attractive Attractive Attractive Attractive Tobacco Neutral Attractive Attractive Attractive Neutral Liquor Attractive Attractive Neutral Attractive Beer/Soft Drinks Negative Attractive Neutral Attractive Negative Negative Food & Snacks Negative Attractive Attractive Attractive Negative Negative Neutral Source: UBS Asset Management. 14 Riding a new wave Emerging Markets: The new normal

15 The rise of the Emerging Market consumer non-working age to working-age population) Rapid changes in consumption patterns occur when consumers move from lower annual income (approximately USD 1,000 to 5,000) to middle income (above USD 5,000). Notably, Bangladesh, Egypt, India, Indonesia, and Philippines are all poised to go through this transition in income levels. Typical consumption shifts are characterized by a rising share of discretionary spending. Exhibit 6. Middle class population and working age population estimates % of household in middle class Population in middle class, '000s Working age population ('000s) Dependency Ratios* Country E E CAGR E CAGR E India 20% 41% 241, , % 748, , % 61% 69% China 25% 51% 339, , % 944, , % 44% 54% Mexico 40% 69% 47,447 93, % 76,092 90, % 56% 50% Indonesia 19% 50% 69, , % 150, , % 60% 56% Turkey 41% 59% 29,647 55, % 47,790 55, % 51% 48% Brazil 29% 48% 57, , % 134, , % 47% 43% Argentina 39% 58% 16,077 26, % 26,268 29, % 57% 56% Philippines 17% 64% 49,525 70, % 55,000 67, % 70% 65% Malaysia 80% 95% 22,621 31, % 18,256 21, % 55% 53% Saudi Arabia 50% 55% 14,045 18, % 18,768 23, % 50% 44% Poland 60% 80% 23,145 30, % 27,600 25, % 40% 51% Thailand 80% 92% 53,122 62, % 44,985 44, % 48% 54% Korea 100% 100% 48,455 50, % 33,039 32, % 47% 57% Russia 48% 86% 143, , % 103,105 95, % 39% 50% 1,295,199 2,287, % 2,508,960 2,671, % Source: UN Population prospects, McKinsey, ADB, IMF, BCG, EIU, J.P Morgan estimates *Dependency ratio is the sum of the number of young and the number of elderly people at an age when both groups are generally economically inactive, (i.e. under 15 years of age and aged 65 and over), compared to the number of people of working age (i.e years old). The data on middle class is from Exhibit 7. Developed-market consumption patterns offer a roadmap to evolving emerging markets (2015) Commodities Durables Services Washing machines Energy Meat protein Wheat Congo India Vietnam Copper Egypt China Cars South Africa EM Average Brazil Dishwashers Chile Turkey Ad spending Luxury cars Russia Portugal Czech Republic Domestic tourism Insurance France Germany International tourism DM Average United States 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 50,000 55,000 Source: Goldman Sachs Global Investment Research. Note: GDP per capita is PPP adjusted. Per capita income (USD) Riding a new wave Emerging Markets: The new normal 15

16 The rise of the Emerging Market consumer Rising wallet share for discretionary spending in EM Consumption and income data across various markets show that 1) staples (basic items like food and clothing) typically tend to follow a plateau consumption curve; while 2) discretionary items (leisure and entertainment, health, education) typically follow a continuous growth pattern/ have multiple inflection points. Exhibit 8 illustrates how spending patterns have changed in China over the 23-year period over Wallet share of food has declined meaningfully and has been allocated to healthcare, recreation and education. Indeed, these trends are visible in other emerging markets and are likely to continue with rising affluence. Quick service restaurants (QSR) With rising income, consumers tend to eat out more often and also trade up from informal food stalls to formal QSR formats which offer better quality food (food safety) and a more conducive dining environment. In the US, consumers spend on average USD 620 annually on fast food versus Japan and Korea at USD 250, Latin America at USD 150, and China at USD 100. The QSR market size in key markets like Thailand, Philippines and India is expected to grow at a compound annual growth rate (CAGR) between 7%-14% over , according to Euromonitor. Exhibit 8. China consumption expenditure per capita Sub-category spend as % of total expenditure per capita 60% Decreasing % of total consumption Increasing % of total consumption 50% 40% 30% 20% 10% 0% Food Clothing Household Facility Medicine Transport & Communication Recreation, Education Residence Others Source: NBS, CEIC. Exhibit 9. Estimated quick-serve restaurant market size CAGR over % 10% 5% 0% Mexico South Korea Brazil China Malaysia Thailand Philippines India Source: Euromonitor, JPM. 16 Riding a new wave Emerging Markets: The new normal

17 The rise of the Emerging Market consumer Leisure and entertainment Rising income levels drive strong growth in leisure and entertainment spending, and a significant gap exists between EM and DM economies. For instance, per capita spending on box office in the US is 10 times higher than in China and 24 times higher than in India. Mexico and Brazil are also well below DM levels. In terms of box office screens, India shows huge potential for growth with seven screens per one million people, amongst the lowest in EM. China too, has only 16 screens per million. China's box office has grown rapidly in recent years, from USD 0.9 billion in 2009 to USD 4.7 billion in 2014, implying 39% CAGR. India's box office revenues are expected to grow at a 10% CAGR over E, according to company reports. Premiumization EM consumers trading up to more premium products EM consumers are willing to upgrade and accept price increases in categories that improve their quality of life. In China, the upgrade trend is visible in a majority of staple and discretionary fields over the past years. Consumer behavior has gradually shifted toward healthier choices, in terms of food safety and focus on quality. The dairy sector in China had been characterized by low-end products historically and is seeing a major change since 2012 mainly driven by two leading players working on premiumization successfully. Both dairy companies Inner Mongolia Yili Industrial Group and China Mengniu Dairy have increased their share of high-end products Exhibit 10. Per capita recreation and culture spend vs income per capita 4,000 Per capita recreation and culture spend 3,500 3,000 2,500 2,000 1,500 South Africa France Canada Australia 1,000 Colombia Poland Indonesia Turkey 500 Portugal India Russia Mexico ,000 20,000 30,000 40,000 50,000 60,000 70,000 Income per capita Source: CEIC, OECD, World Bank. Japan U.K. U.S.A. Exhibit 11. China s beer sales mix to mid/high-end and low-end Proportion of Total beer sales 90% 88% 86% 84% 82% 80% 78% 76% 74% 25% 20% 15% 10% 5% Proportion of Total beer sales 72% 0% Low end (LHS) Mid/high-end (RHS) Source: Euromonitor. Riding a new wave Emerging Markets: The new normal 17

18 The rise of the Emerging Market consumer from 30%-40% three years ago to 40%-45%, according to company reports. China s mid/ high-end beer sales also increased from 11% of total sales in 2001 to 22% in In India, a consumer shift toward premium or value-added products is emerging as a key driver for improved performance for most consumer companies. Premium and emerging segments within personal care are growing at 1.5 times the category growth rate. Consumer companies are making disproportionate investments to enhance consumer awareness regarding those offerings to encourage consumers to trade up. Online shift beginning to disrupt legacy distribution channels The online retail market in EM could reach over USD 2.5 trillion by 2025, representing a 13% CAGR from current levels. 5 Consumers still use online services primarily for social network and gaming, but online shopping is becoming increasingly entrenched. Among emerging markets, China leads the pack with e-commerce penetration at ~13.5% of total retail sales in 2015, almost in-line with the US at 13.8% of comparable retail spend, according to Credit Suisse. Importantly, it took China about five years to move from ~2% e-commerce penetration to ~14% e-commerce penetration, while the US took over 10 years to achieve that. This rising share of online trade is disintermediating traditional distributors. Specifically, rising on-line penetration in China has been accompanied by declining same-store sales for traditional retailers. Traditional retailers like Lifestyle, Golden Eagle, Trinity, Belle and Daphne have seen their same-store sales growth turn negative over the past couple of years. Exhibit 12. China e-commerce sales as % of total retail sales 20% 15% 10% 5% 0% Source: JPM. Exhibit 13. Average same-store sales growth trends for key China traditional retailers* 25% 20% 15% 10% 5% 0% -5% H H H Volume Pricing Source: Company data; JP Morgan; *Traditional retailers include Lifestyle, Golden Eagle, Daphne and Belle. 5 Credit Suisse Emerging Consumer Survey Riding a new wave Emerging Markets: The new normal

19 Chapter 3 Healthcare: Growing demand and innovation Riding a new wave Emerging Markets: The new normal 19

20 Healthcare: Growing demand and innovation Demand for healthcare services grows Another consequence of EM demographics is the rise of the healthcare sector. Rising income across EM is driving demand for good quality healthcare services while rising affluence also leads to higher incidences of lifestyle-related diseases (obesity, heart disease etc.) and thus a greater need for healthcare services. According to the OECD, Thailand, the population aged over 60 is estimated to increase from 15% of total in 2012 to 23% in India s population above 45 years old is expected to increase from 22% of total population in 2012 to 26% by India's population over 60 years of age is expected to increase from 8% in 2012 to 11% in Similarly, Malaysia is expected to see 15% of its population above 60 years of age in 2021 (vs. 9% in 2013). Equally, the over 65 population in Brazil should double and reach 14% of the total by In South Africa, the population aged 65+ has already reached 14% today, which is close to the OECD average. The Middle East also represents an attractive growth opportunity given rapidly growing lifestyle disease burdens. Private expenditure on healthcare in countries like India, Vietnam, Indonesia, Philippines and China has seen double-digit growth over the past few years. According to the World Health Organization, healthcare spending as a percentage of GDP in Emerging Asia is 3%-7% and trails that of developed markets at 9%-11% (i.e. Japan, Australia, Europe) and 17% for the US. Ex-Asia healthcare spending in countries such as Brazil and South Africa as percentage of GDP is comparable to DM levels, although the level of service is much more basic. South Africa specifically has a high burden of disease due to HIV. Globally, spending levels on health have to be at least 5%-6% of its GDP to meet basic healthcare needs, typically with a major part from government expenditure. The private healthcare services operators in EM will benefit from increasing demand and spending. Governments in EM also need private healthcare service operators as the public healthcare infrastructure has not been able keep up with demand. Pharmaceuticals: Growing Innovation in Korea and China We see increasing innovation supporting economic development in EM. In the pharmaceutical sector, our benchmark for innovation in the biotech sector is pharmaceutical companies that research and develop new chemical entities and/or biologics for treatment of disease and illnesses. We see early evidence of a biotech sector emerging, particularly in China and Korea, with increasing efforts to create a world-class biotechnology industry in both countries. We believe there are potential opportunities Exhibit 14. Growth in private expenditure on healthcare CAGR % 15% 10% 5% 0% India Viet Nam Indonesia Philippines China South Africa Brazil Maysia Mexico Thailand Source: World Health organization. 20 Riding a new wave Emerging Markets: The new normal

21 Healthcare: Growing demand and innovation in EM in leading pharmaceutical companies that successfully break through the innovation frontier. We also see attractive investments in pharmaceutical companies even if they are not involved in leading-edge biotech research, so long as they are still innovating and differentiating their products. Reverse brain drain and multi-national corporations' (MNC) investments In 2008, the Chinese government instituted the 'Thousand Talent Plan' to entice Chinese-born scientists living overseas to return and develop the domestic biotech industry. It has attracted more than 4,180 top-level scientists as of mid The cumulative number of returned PhD holders reached 110,000 in At the same time, the number of job opportunities in global pharma companies was reduced to right-size their cost base for the pending patent cliff in early 2010s. As R&D divisions were restructured, the brain drain was reversed, which helped kick start development of the pharmaceutical industry in their home countries. 7 As global pharma companies restructure in developed markets they are also investing in emerging markets such as China and India. For example, GlaxoSmithKline plc (GSK) has set up an R&D center in China to tailor drugs for the large domestic market. We expect that its investments will help train local scientists and introduce more advanced products/technologies to the Chinese market. The market potential is sizable in China, as the world's second largest market for medical drugs (after the US) is currently underserved and the aging population provides sustainable long-term demand. Government policy changes encourage innovation In China and Korea, government policies controlling pricing of generic drugs pushed the pharmaceutical industry to invest in innovation as margins for generics began to shrink. With the cost of R&D also increasing, companies turned to higher-value drugs for better returns, rather than to low-value generic drug candidates. To diversify from risks they saw in the domestic market, these companies also shifted their Exhibit 15. Compound annual growth rate of biomedical R&D expenditures by country , adjusted for inflation CAGR calculated on the basis of total inflation-adjusted biomedical R&D expenditures in USD for 2007 and 2012 Canada -2.6 United States Europe Taiwan Japan India 6.7 Australia 6.9 Singapore South Korea China % 0% 5% 10% 15% 20% 25% 30% 35% Compound Annual Growth Rate of Biomedial R&D Expenditures Source: Justin Chakma, B. G. (January ). Asia's Ascent Global Trends in Biomedical R&D Expenditures. The New England Journal of Medicine. As of Jan Riding a new wave Emerging Markets: The new normal 21

22 Healthcare: Growing demand and innovation focus overseas; for overseas markets, highquality and innovative products are needed to differentiate. Fast pace of R&D spending in Asia (especially South Korea and China) While the absolute level of EM R&D spend is low compared to developed markets (US, Europe and Japan), a study showed that Asia has shown the greatest gains in global biomedical R&D spending, especially in China and Korea. 8 The South Korean experience In the early 2000s, the South Korean pharma sector was benefiting from supernormal profits selling generics in the domestic market; thus there was limited incentive to invest in R&D in innovative drugs. By 2011, the Korean government had introduced policies to reduce generic pricing by up to 47% over two years to alleviate rising public healthcare expenses and a deficit in the National Healthcare Insurance Service. In 2013, the government launched the Pharma Vision 2020 plan to promote the domestic pharmaceutical industry, including committing KR10tr to R&D from , tax breaks for R&D in new drugs, streamlining the approval process for new drugs, and supporting domestic companies expanding overseas. The Korean government also started to build bio-tech hubs in Taegu and Osong, similar to those found in the US and Japan. 9 The number of out-licensing deals done by Korean pharma companies to global pharma companies has been increasing over the years. This is reflective of improving R&D quality in Korea that is increasingly being recognized by global pharma companies. The Chinese experience In 2009, the Chinese government started medical reforms and put in place wider healthcare insurance, increasing coverage from 45% of the population in 2006 to 90% by the end of 2009, according to Sussmuth-Dyckerhogg. In an attempt to push drug prices down and manage potential deficits in the insurance funds, the government introduced stringent drug tender rules in different provinces. In the twelfth Five-Year Plan ( ), the pharmaceutical industry was named as one of the seven industries to replace China's 'old' economy pillar industries that would support economic growth going forward. This should be reinforced in the thirteenth Five-Year Plan ( ). The Nature Index 10 shows that China was the fastest-growing and largest contributor of published academic research articles by Weighted Fractional Count (WFC) 11 from China s contribution grew 37% from 2012 to 2014 compared to a 4% decline for the US over the same period, according to Zhou. Exhibit 16. Number of out-licensing deals to multi-national companies by Korean pharma companies Source: Ministry of Food and Drug Safety Korea, Citi Research. 22 Riding a new wave Emerging Markets: The new normal

23 Healthcare: Growing demand and innovation Exhibit 17. China Booming This cross-section of countries in the Nature Index shows how remarkable China's increase in high-quality science output has been in recent years. 2,000 1,500 1,661 China s rapid growth outshines all other nations. Change in WFC ( ) 11 1, The research output of traditional stronghold in the Nature Index, the United States, dropped by 4% , China India Switzer. Australia Russia Singapore Austria UK Germany France Japan US Source: Nature Publishing Group. Exhibit 18. The number of chemical category 1.1 (most innovative) IND and NDA applications to China FDA is accelerating Category 1.1 refers to new drugs that have not been approved in China or rest of world Number of chemicals 1.1 category applications to China FDA Investigational new drug New drug application Source:GBI, CFDA, and Bernstein analysis. Riding a new wave Emerging Markets: The new normal 23

24 Healthcare: Growing demand and innovation Pharmaceuticals innovation in the rest of EM Outside of China and South Korea, there is less opportunity for pharmaceutical innovation in other global emerging markets. Governments have had less incentive to push drug pricing down because healthcare expenses are still largely paid out of pocket. As a result, governments are not facing as much funding pressure in public healthcare budgets. Pharmaceutical companies in the rest of EM have not had a regulatory push to expand into more innovative and R&D-intensive areas. There are also structural deficits that may prevent creation of intellectual capital in the medium- to longer-term, thus limiting pharma innovation in several countries. There is a lack of high quality educational institutions involved in research. There is also limited risk capital available, either from governments or venture capital. Weak patent protection in most major EMs is also a challenge. Nevertheless generics companies in EM can represent attractive investment opportunities. For instance, some companies have started to focus on generics with more complex production processes and expansion into bio-similar type of products that are more difficult to replicate through generics. 6 Zhou, Y. (December ). The Rapid Rise of a Research Nation. Nature Journal. 7 Hirschler, B. (June ). Drug R&D spending fell in 2010 and heading lower. Reuters. 8 Justin Chakma, B. G. (January ). Asia's Ascent Global Trends in Biomedical R&D Expenditures. The New England Journal of Medicine. 9 Ward, C. T. (April ). Healthcare and Life Sciences Industry as a Strategic Focus for South Korea. The National Bureau of Asian Research. 10 The Nature Index is a database of author affiliation information collated from research articles published in an independently selected group of 68 high-quality science journals. The database is compiled by Nature Publishing Group (NPG). The Nature Index provides a close to real-time proxy for high-quality research output at the institutional, national and regional level. 11 Article output is counted in three ways: 1. Article count (AC): where a count of one is assigned to an institution or country if one or more authors of the research article are from that institution or country, regardless of how many co-authors there are from outside that institution or country. 2. Fractional count (FC): that takes into account the percentage of authors from that institution (or country) and the number of affiliated institutions per article. For calculation of the FC, all authors are considered to have contributed equally to the article. The maximum combined FC for any article is Weighted fractional count (WFC): a modified version of FC in which fractional counts for articles from specialist astronomy and astrophysics journals have been down weighted. These journals encompass a much larger proportion of the total publication output of these fields than any other field covered by the Nature Index. The WFC allows ordering of institutions and countries so as not to give undue emphasis to these fields. The weighting is achieved by multiplying the fractional count from these astronomy and astrophysics journals by a factor of 0.2. This down weighting is in proportion to an approximation of the level to which astronomy and astrophysics articles are overrepresented compared to the total publication output of other fields covered by the Nature Index. Definitions extracted from 12 Carney, L. N. (November 25, 2015). China 2016 (Part 2): Leading-Edge Chinese Technology? Bernstein Research. 24 Riding a new wave Emerging Markets: The new normal

25 Chapter 4 Information Technology: Global and domestic opportunities Riding a new wave Emerging Markets: The new normal 25

26 Information Technology: Global and domestic opportunities The information technology (IT) sector is highly global, and many EM IT companies compete directly with their global peers. Within the sector, each industry group will face different opportunities and challenges over the next five years, depending on how intense competitive forces are. The industry groups can be loosely classified into two categories: 1. Industry groups with relatively more exposure to the domestic EM economies, including: Internet software and services Software 2. Industry groups that are relatively more exposed to global demands, including: Communication equipment Electronic equipment instruments and components Semiconductor and semiconductor equipment Technology hardware storage and peripherals IT services Industry groups with relatively more exposure to domestic economies We see good investment opportunities in the internet space for EM in the New Normal. The internet has and will continue to see very good growth potential in EM. Historically, the internet has been about creating and growing new market segments, and we expect this trend to continue. In addition, we expect existing market segments such as e-commerce and digital ads, searches, online/mobile gaming, videos and online travel/property/autos to maintain their good growth momentum in the selected markets. In addition, EM countries are at different stages of digital development. Despite already high internet penetration in parts of EM (particularly in Asia), there are many countries where internet access is available to less than half the population. Connectivity will become more affordable and accessible, especially with cheaper mobile Exhibit 19. Internet penetration (Nov 2015) across our key EM countries significantly lags behind DM Norway Denmark Netherlands Sweden New Zealand Finland Australia Canada South Korea United Kingdom Japan Germany USA Switzerland Belgium France Russia Turkey Brazil China Mexico South Africa Indonesia India 0% 20% 40% 60% 80% 100% Source: internetworldstatistics.com 26 Riding a new wave Emerging Markets: The new normal

27 Information Technology: Global and domestic opportunities devices. According to Pew Research, in India, two-thirds of internet access is through smartphones; in China, it is over 50%. If internet usage across EM matures to the levels found in developed markets, there could be an additional two billion internet users across EM countries. Internet companies have been taking market share from traditional businesses in the past and this will continue in the New Normal. Internet companies' level of market penetration in developed markets for various market segments acts as the benchmark that EM companies may be able to achieve domestically. And even these may be upwardly moving targets. In fact, the level of penetration of online services in selected EM markets has even exceeded that of their DM counterparts, such as in online advertising. The internet will continue to disrupt many traditional retail industries and even create new business models unthought of just five or 10 years ago. Internet companies in China arguably started as followers, but more recently have been very innovative in extending the breadth of service offerings for the domestic market's needs. One may in fact argue that the less developed or weak traditional commerce infrastructure in many EM countries lends itself naturally to a faster and higher growth potential for these internet companies. In many cases, we even see incumbent companies embracing new Exhibit 20. Share of smartphone owners using the device for internet access rapidly increasing across all surveyed countries 100% 80% 60% 40% 20% 0% Brazil China India Indonesia Russia Saudi Arabia South Africa Turkey Mexico Source: Credit Suisse Emerging Consumer Survey Exhibit 21. Online ad share as a percentage of total ad revenue is higher in some EM countries than DM 60% 50% 40% 30% 20% UK China US Russia Germany Korea Taiwan Brazil Japan India 10% 0% China India Taiwan Brazil Russia Korea US UK Germany Japan Source: Magna, emarketer, Credit Suisse estimates. Riding a new wave Emerging Markets: The new normal 27

28 Information Technology: Global and domestic opportunities technologies that may disrupt their traditional service offerings as the latent cost of existing infrastructure is much lower compared to their developed market counterparts, none more so than in the telecom sector. Thus we believe e-commerce in EM will continue to grow and even accelerate in the New Normal. We have already witnessed the rise of a number of internet service juggernauts in less than 10 years of development in the likes of China and Russia. While these companies should continue to grow in the New Normal, the next phase of growth and investment opportunities may well be found in the likes of India and Southeast Asia. Exhibit 22. E-Commerce as % of total retail sales 20% China 15% Globally 10% 5% Russia Brazil India 0% E 2016E 2016E 2018E China Brazil Russia India Globally Source: MS Research. Exhibit 23. Online retail as % of total retail sales Growth across all markets, with most potential still across EM China UK South Korea US World Germany Japan Australia France Spain Brazil Italy India Indonesia Mexico 0% 5% 10% 15% 20% Source: e-marketer, Credit Suisse Research. 28 Riding a new wave Emerging Markets: The new normal

29 Information Technology: Global and domestic opportunities Industry groups that are relatively more exposed to global demands For these industry groups, outsourcing has been a significant growth driver. We observed this most in the case of electronics manufacturing services as well as IT services. The companies in EM, particularly in Taiwan (leveraging off production bases in China) benefited as global brands outsourced their manufacturing for selected products to these parts of the world mainly taking advantage of the cost arbitrage. Over time, the cluster effect helped improve efficiency of the entire supply chain, benefiting both parties. Likewise, IT services companies in EM, particularly in India, have used the offshoring model to grow significantly fueled by events such as Y2K (also known as the millennium bug) and the growth of the internet. However, much of this outsourcing growth may have run its course. Today, most of the world's desktop PCs, notebook PCs, mobile phones, TV sets and game consoles are already assembled in EM. Likewise, we are seeing slowing demand for offshoring of IT services, while changing political circumstances create possible employment barriers in developed economies for these EM IT services companies. Thus, the investment case for these EM industries in the New Normal will be one where the companies are globally competitive. These companies will be subject to the same competitive forces that their global counterparts will face. So, picking winners here will be quite similar to picking global winners. In particular, there will be EM companies that are able to migrate up the value chain. The technology sector's history has been littered with instances of leaders being displaced and products being made obsolete. So past performance will definitely not be an indicator of future success. However, selected opportunities exist for EM companies that are able to move up the value chain. This may be done either through their own offerings or through helping their customers provide higher value-added products or services. We see possibilities in several selected areas, including semiconductor and IT services. At the same time, with moderating growth, industry consolidation will inevitably follow. In the past, EM technology companies, particularly in Asia, invested significant capital in select industries such as DRAM (dynamic random access memory), NAND (not-and), display panels, LED (light-emitting diode) and solar components (polysilicon, cells and modules). Overall industry supply side discipline is very poor during such periods of significant investment resulting in overcapacity and generally poor returns over the cycle. Some in the market may describe these industries as producing commoditized products that would see decreasing margins. But the silver lining is that competitive forces will result in less competitive companies exiting the industry. The remaining companies, particularly the industry leaders, should thus make good profit even during down cycles. Globally, we have observed that in the hard disk drive industry. Exhibit 24. DRAM market consolidating to 3 players Unit share 100% 80% 60% 40% 20% 0% Elpida Samsung Qimonda Micron ProMOS Hynix Powerchip Nanya Others Source: STM, Credit Suisse estimates. Riding a new wave Emerging Markets: The new normal 29

30 Information Technology: Global and domestic opportunities Exhibit 25. DRAM margins improve as the industry consolidates Operating Margin (%) 60% 40% 20% Samsung Inotera Hynix Micron 0% -20% -40% Powerchip -60% Elpida -80% -100% ProMOS 2015 Samsung Hynix Micron Inotera Elpida ProMOS Powerchip Source: STM, Credit Suisse Estimates. More pertinent to EM, we observed that trend in the DRAM industry where consolidation eventually led to a better industry structure benefiting the surviving leaders. Currently a number of industries in EM are at a similar stage as where the DRAM segment was five to 10 years back, with companies experiencing poor returns given the unfavorable industry structure. However, consolidation should occur going forward and the surviving industry leaders can be good investment candidates in the New Normal. These industries would include NAND, TFT LCD (thin-film transistor liquid-crystal display), LED and solar components and may be good investment opportunities in three to five years. A final thought on Information Technology On a parting note, we haven't even started to discuss impending disruptors in this sector yet. FinTech, short for financial technology, may be defined as companies that use technology to make financial services more efficient. While software and the internet will be the core of most FinTech companies that may disrupt incumbent financial systems, the entire sector supply chain, from semiconductor to network infrastructure and IT services, will form part of the required building blocks. Likewise, virtual reality/augmented reality will change the way we work and live in the future. These innovations will continue to grow and create value in the New Normal. 30 Riding a new wave Emerging Markets: The new normal

31 Chapter 5 Financials: Bank value drivers in the New Normal Riding a new wave Emerging Markets: The new normal 31

32 Financials: Bank value drivers in the New Normal Lending/top-line growth during slower GDP growth We examined loan penetration rates of countries in EM relative to their GDP/Capita levels. Low penetration rates create the platform for financial sectors in these countries to grow even in the absence of high economic growth. However, we recognize that low penetration alone, while being a key ingredient, is not the only determinant of financial sector growth. Therefore, we will then look at the availability of liquidity to fund it (loan/deposit ratios 100%). We will also examine the recent growth in penetration to see: a) if growth has been excessive, and/or b) if there is a positive recent trend/momentum. Where do we stand? There is no precise link between loan penetration and GDP/Capita, hence, we focus on outliers. Countries with low penetration can leverage up, and these include Indonesia, Mexico and Hungary. Conversely, countries like China, Malaysia, Thailand, Taiwan, South Africa and Greece show high credit penetration, and very likely will have to deleverage sometime in the future. Recent trends/momentum Generally, the momentum is positive and relatively sustainable across most markets, but we see excessive growth in three countries, China, Turkey and Colombia. On the other hand, Hungary has deleveraged significantly, and we need to see if and when this trend stops. Greece and Taiwan have also been deleveraging recently. Availability of liquidity to fund loans On loan/deposit ratios, which we believe represent the financial sector's capacity to fund any increase in credit penetration, the picture is mixed. A part of our universe looks fine, without funding constraints on growth, while the other part seems to have funding problems. For the latter, one would have to look into whether funds are available within the country, other than in bank deposits, in which case there is no fundamental issue (e.g., Brazil, Chile or Mexico). In other countries, such as Turkey or Greece, there is a genuine shortage of savings in the country to fund growth, and hence any growth is reliant on the highly volatile external funding. We see no quick fixes for Turkey and Greece: In Turkey, this is a structural issue with a very low savings ratio at single-digit to low teens as a percentage of GDP and in Greece, it is a result of capital flight amid Grexit fears. We should generally be cautious on countries with insufficient internal funding. The results above indicate that only a few countries have all the key drivers in place to deliver higher financial sector growth through increased penetration alone. These would include countries like Indonesia and Mexico, or Hungary, to a lesser extent. They have a better chance than others to succeed, but would still require policies and government action to be supportive. On the other hand, a few countries show unsustainable penetration and/or momentum of leveraging and could see some correction in the future (most notably China, but also Turkey and Greece). Exhibit 26. Penetration - credit/gdp vs GDP per capita Credit as % of GDP China Malaysia South Africa 100 Chile Korea Turkey 80 Thailand India Russia Czech R. 60 Poland Brazil 40 Peru Hungary Colombia Mexico 20 Indonesia Philippines 0 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 GDP per capita in USD Source: JPM Research, data as per February yr % change in credit to GDP Mexico Indonesia Source: JPM Research, data as per February Credit as % of GDP Greece Taiwan Exhibit 27. Three-year change in credit/gdp vs. credit/gdp Philippines Colombia Peru Poland Brazil Russia Hungary India Turkey Korea Czech R. Chile South Africa Thailand Malaysia Greece Taiwan China Riding a new wave Emerging Markets: The new normal

33 Financials: Bank value drivers in the New Normal Exhibit 28. Loan/deposit ratio (%) in excess of 100% by: 80% 60% 40% 20% 0% -20% -40% Brazil Greece Turkey Chile Colombia Mexico Korea South Africa Peru Poland Thailand Indonesia Malaysia Russia India Hungary Czech R. Taiwan China Philippines Source: JPM Research, data as per February Drivers below the top line As we have seen above, without high economic growth and structural impetus to improve credit penetration, the focus on the financial sector might shift away from top-line revenue growth into potential for earnings or cash return improvements. We examine several key variables, including potential for improvements in efficiency, net interest margin, cost of risk and dividends that can drive individual share price performance. Efficiency We will look at the cost-to-assets ratio for banks in our universe to gauge the potential for efficiency gains and earnings growth, in the absence of top-line growth. We will contrast this with cost-to-assets ratios for DM banks. The potential for cost reductions relative to DM banks is not a given. As Exhibit 29 demonstrates, the DM banks cost/asset ratios range from 1.2% in the EU to 2.6% in the US. Only Exhibit 29. Cost/Assets 5% 4% 3% 2% Average DM banks: US 2.6% and EU 1.2% 1% 0% Bradesco Credicorp OTP BCA BRI FSR BGA Itaú Mandiri IndusInd Bank PNB BDO KBANK SBK Banorte HDFC Bank Garanti Sberbank PKO Pekao San Chile BPI CIMB Axis Bank SBI ICICI Bank SCB Akbank VTB BBL Komercni MAY CMB UOB ICBC BOC DBS CCB Citic OCBC PUBLIC Source: Morgan Stanley, data as of February Riding a new wave Emerging Markets: The new normal 33

34 Financials: Bank value drivers in the New Normal a handful of banks in our universe stand out as being relatively inefficient (most notably Brazilian, South African and Indonesian banks) and offering potential to improve. The sensitivity/leverage to cost-cutting is high though. The average cost/asset for our universe stands at 2.2%. Reducing this by 10bps (or cost base by 5%) can improve ROEs by100bps and earnings by approximately 7% (assuming 15% normalized ROE). There is therefore a significant potential for earnings growth despite tepid top-line growth, providing banks have good execution. The savings could come from reducing branch networks, moving to mobile/e-banking, paperless transactions or account maintenance, less account servicing, more cross-selling and better customer relationship management systems. Cost of funds limited room for improvement Overall, the funding situation among the EM banks is good, with loan/deposit ratios at or below 100% for the vast majority of them. In theory, in an environment where loan growth slows down, banks would need less deposits (or fundings), and would therefore be able to pay less for deposits and increase their margins. However, there seems to be limited room to improve cost of funds for EM banks despite the likelihood of slowing loan demand leading to less competition for deposits. Indeed, except for a few outliers, most banks already have positive liability spreads, i.e., the difference between the Exhibit 30. Liability spread vs. LDR Liability Spread 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% Sberbank interbank rate (or the rate at which banks lend to each other) and the cost of funding, is already positive. Low or falling interest rates could in fact pressure net interest margins. Cost of risk should improve VTB San Chile LDR (loan to deposit ratio) We expect slower growth to lead to longer-term improvements in the cost of risk, on top of the upcoming shorter-term cyclical improvement (many banks in EM are coming off their negative asset quality cycle driven by previous high loan growth). Exhibit 30 demonstrates that the average cost of risk of ~1.8% is relatively high vs. sub-1% for DM markets. Every 10bps improvement will translate to 8bps ROA improvement and approximately 5% earnings improvement. Bradesco -4% 50% 75% 100% 125% 150% 175% 200% Source: Morgan Stanley, data as of February Exhibit 31. Provisions/average loans (2015) 5% 4% 3% 2% 1% 0% Itaú Bradesco Mandiri CMB BRI OTP Citic CCB BGA ICBC BCA BOC Credicorp FSR Banorte SBK Sberbank ICICI Bank VTB San Chile KBANK SBI SCB Akbank Garanti Axis Bank IndusInd Bank CIMB BBL PKO HDFC Bank BPI MAY Pekao UOB Komercni DBS OCBC BDO PNB PUBLIC Itaú Source: Morgan Stanley, data as of February Riding a new wave Emerging Markets: The new normal

35 Financials: Bank value drivers in the New Normal Dividends potential upside As banks in EM have capital levels built for high growth and high credit costs, there is room for banks to return surplus capital to shareholders. We estimate that surplus capital at banks is as high as 8% above minimum regulatory requirements or 3.6% on average. Slower risk-weighted assets (RWA) growth, even with lower normalized ROE assumptions, means that dividend payouts can increase from an average 38% to high 40s, assuming stable capital ratios. This could lead to nominal dividends rising by as much as 50% on average, all else being equal. If we would assume some capital ratio optimization, the average payouts could rise above 60% for the next five years. FinTech poses a risk As mentioned, FinTech provides opportunities but it also poses a risk for bank earnings. We believe the most basic transaction/payments, like credit card, funds transfer, foreign exchange and remittances, are the most ripe for disruption, and these fees contribute from 20%-40% of pre-tax profits for banks. However, the fee contribution from credit, basic banking services or high-value-added financial services is still low compared to DM banks and therefore softens the impact to disruption of basic fees. Exhibit 32. Surplus capital (%) 10% 8% 6% 4% 2% 0% -2% -4% IndusInd Bank Pekao BBL Akbank PNB KBANK HDFC Bank Garanti MAY ICICI Bank SCB BCA Axis Bank BPI Banorte Credicorp OCBC ICBC CCB BRI PUBLIC CIMB SBI PKO DBS Itaú FSR Mandiri BOC UOB CMB Komercni BDO Bradesco SBK OTP Citic San Chile BGA VTB Sberbank Source: Morgan Stanley, data as of February Exhibit 33. Potential upside (%) to dividends from that distributed in % 200% 150% 100% 50% 0% -50% -100% IndusInd Bank Garanti Sberbank Axis Bank Akbank SBI Banorte HDFC Bank BCA KBANK Mandiri Citic ICICI Bank Itaú Credicorp Note: Surplus capital = Common Tier 1 ratio above required capital level. Source: UBS AM, estimates as of June BRI ICBC CCB BOC CMB Bradesco DBS BDO OCBC BBL BPI PNB FSR CIMB PUBLIC UOB VTB SCB SBK San Chile BGA PKO OTP MAY Komercni Pekao Riding a new wave Emerging Markets: The new normal 35

36 Financials: Bank value drivers in the New Normal Conclusion In a lower growth environment, the banks in EM do have multiple levers to foster earnings and/or dividend growth, and can hence offer select interesting investment opportunities. In the absence of top-line growth, the main source of earnings upside will come from improving the cost of risk and to a lesser extent better cost efficiency. Also, dividend payout ratios can rise substantially. Among the key risks is a relatively high dependence on simple fees, which could be disintermediated by FinTech or just simply competed or regulated away. This exercise is a theoretical analysis showing the potential for improvements. In practice, capturing potential and whether a stock will be an attractive investment will very much depend on the respective markets, regulations and management. 36 Riding a new wave Emerging Markets: The new normal

37 Chapter 6 Commodities: How to profit in a subdued oil price world? Riding a new wave Emerging Markets: The new normal 37

38 Commodities: How to profit in a subdued oil price world? After several years of relative stability in oil markets, with prices ranging slightly above USD 100/bbl, the collapse in prices witnessed during the second half of 2014 (from > USD 100/bbl to sub USD 50/bbl) caught most by surprise. While this movement can be explained by several factors, we see two main events driving this change, which we view as more structural than cyclical: First, the impressive supply increase and the technological improvements from non- OPEC members, especially in non-conventional fields (e.g., US shale revolution), and second, OPEC revaluated its strategy (mainly Saudi Arabia) and switched to an output maximization strategy, realizing that high prices create significant risk of demand destruction over the long term, via a switch to other fuels, especially renewables, and incentivizes non-conventional producers. This strategy shift would result in revenue loss mid-term, but probably will be beneficial in the long term. This sudden change in the market also brought a new challenge for most international oil companies, testing their ability to survive in a wholly different environment. Since the oil price collapse, the average market value of international players has declined by around 40%, with several players reporting losses and burning cash during the period. In the middle of this turmoil, Russian companies have been a positive exception, reporting relatively stronger numbers, generating solid free cash flow (FCF), while keeping their investment plans (on average Russian oil stocks outperformed international peers by ~35% in 2015), illustrated by Exhibit 34.). This superior performance can be mainly explained by Russia's overall low-cost structure, a progressive tax system, and benefits from the currency depreciation. Looking forward, and taking the forward curves as a proxy (understanding all the caveats of this analysis), the market seems to be expecting only a very gradual improvement in oil prices during the next few years, with prices stabilizing at levels well below the previous >USD 100/bbl. In our view, this new scenario of structurally lower oil prices makes a perfect environment for Russian oil companies to continue outperforming their international peers, supported by stronger margins and lower risks on capital allocation. Russia's oil industry shows good potential While Russia is still well behind on the development of non-conventional fields, its low cost and conventional reserves, especially in West Siberia, are already significant enough for the country to top the list for reserve life and reserves replacement ratios (RRR). The country also ranks among the lowest-cost oil producers globally, driven by: 1) its large conventional reserves; 2) a regional service industry (most costs are RUB-based); and 3) benefits from the currency devaluation given the high dependence on oil revenues for the government budget, low oil price is to a certain extent offset by a weaker currency (therefore, the hit from lower oil is passed through to importers and end Exhibit 34. Russian oil sector price performance vs. international peers (rebased to 100 on ) Russian Oils 100 International Oils Oil (Brent) 50 0 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Russian Oils International Oils Oil (Brent) Source: Factset (as of April 2016). (1) Russian oils includes: Rosneft, Lukoil, Surgutneftegas, Tatneft, Bashneft (2) International Oils includes: BP, Eni, Galp, OMV, Repsol, Statoil, RDS, Total, PBR, YPF, XOM, CVX, COP 38 Riding a new wave Emerging Markets: The new normal

39 Commodities: How to profit in a subdued oil price world? Exhibit 35. Estimated oil reserve life (2014) In billions of barrels Exhibit 36. Reserves replacement ratios (RRR) 5 yr average for oil, in billions of barrels Russian oils Petrobras US integrated European integrated Asian oils Russian oils US Petrobras integrated Asian oils European integrated Source: Company reports. Source: Company reports. Exhibit 37. Lifting costs Exhibit 38. Finding and development costs (USD/boe) (USD/boe) Russian avg. TOTAL Statoil BP YPF Petrobras ENI PetroChina ExxonMobil Chevron Russian avg. ExxonMobil Petrobras PetroChina BP ENI Chevron TOTAL Statoil YPF Source: Company reports (2015A). Source: Company reports (2015A). For Exhibits 34-38: (1) Russian oils: Rosneft, Lukoil; (2) US integrated: Total, ENI, OMV, Statoil; (3) European Integrated: Chevron, ConocoPhillips; (4) Asian oils: CNOOC, PetroChina. 2015A / Russian avg. includes: Rosneft, Lukoil, Surgutneftegas, Tatneft, Bashneft. consumers eventually). These characteristics allow Russian oil producers to deliver one of the lowest lifting costs in the industry (average of <USD 4/boe vs. international peers above $10/boe), develop a very efficient reserve base, report finding & development (F&D) costs well below global players, and achieve capex per barrel more than two times lower than international peers. In addition, a flexible taxation system is also key in supporting the sector s superior performance on profitability and FCF generation in a lower oil price environment. Russia has a progressive tax scale linked to the oil price, resulting in lower taxes when prices are declining, and taxing away excess profits when oil prices are rising (offering a natural hedge against falling oil prices). This unique combination of low-cost reserves, FX hedges, and a flexible taxation system gives Russian players a competitive advantage that is unmatched in the global oil industry, and allows the local industry to be able to continue spending on scheduled investment plans. In the past, Russian oil companies performance were usually impacted by poor investment decisions, including questionable M&A activities, and failure to reward shareholders even in the peak of the cycle. However, with subdued oil prices, we expect a more disciplined and cautious approach in capital allocation decisions, with continuous focus on cost cutting and efficiency gains, thus supporting share price performance. Risks A key risk when investing in the sector remains the potential for higher taxation given the industry's importance for the budget and historical precedents. Although this risk cannot be ruled out, an environment of rising oil prices (even at a slow pace) should relieve the pressure, and the Riding a new wave Emerging Markets: The new normal 39

40 Commodities: How to profit in a subdued oil price world? government is also considering other measures such as privatization of some companies, raising the tax burden for consumers and higher dividend payouts at selected state companies. In addition, the government understands the negative impact on the broader economy if investments from the oil industry decline sharply due to substantial tax increases for the sector. Petrochemicals a commoditytype business Outside the oil and gas sectors, expected beneficiaries of a benign oil price environment include petrochemicals and a number of processing, manufacturing and industrial sectors where the price of oil is a significant influence on the variable costs of that industry. Petrochemicals are a commodity business, where cost/price leadership is the key driver of competitive advantage. The raw materials used in this industry are refinery products of the oil and gas industry, hence low oil prices equate to lower input costs. For most petrochemicals, there exists a strong correlation between the commodity price to that of crude oil itself, but the margins earned depend on the product spread over the underlying commodity. That spread is typically a function of the balance between supply and demand when demand growth exceeds supply growth, the market tightens and spreads often increase, but when supply growth exceeds demand growth, spreads tend to decrease. Ethylene, a basic building block for most plastic polymers and chemical intermediates, is often used as a proxy for the petrochemicals industry as a whole. Exhibit 39. Upstream capex per barrel (USD/bbl) vs. European peers Russian average BP Eni Repsol Shell Statoil Total Source: Bloomberg Finance, LP. Russian avg. includes: Rosneft, Lukoil, Surgutneftegas, Tatneft, Bashneft As illustrated below, the global chemicals industry is currently enjoying a period of relatively high margins as the industry's utilization rate remains elevated, a result of a reduced rate of capacity additions over the past four years. Three key factors have contributed to the latter phenomenon: 1) a prolonged downturn for naphtha-based producers in Europe and Asia in the early part of this decade, 2) the advent of shale-gas based crackers in the US, which appears to have frightened off capacity addition from less competitive rivals in the industry, and 3) delays and cancellation of coal-to-olefins (CTO) or methanol-to-olefins (MTO) facilities in China which required high oil prices in order to remain competitive. With reduced capacity additions until 2020, we expect the supply and demand to remain Total Statoil / Shell Repsol / Eni BP Russian average Exhibit 40. Global ethylene supply/demand and utilization rate, , , , , , ,000 80, , World DD 000t (LHS) World SS 000t (LHS) Utilization % (RHS) Sources: Bloomberg Finance, LP, Reuters, IHS Chemical Data, ICIS, UBS Asset Management. 40 Riding a new wave Emerging Markets: The new normal

41 Commodities: How to profit in a subdued oil price world? balanced into the latter part of this decade. Should global GDP surprise on the upside or should planned ethylene expansions be, almost inevitably, delayed, there is scope for industry utilization to improve beyond our expectations, resulting in higher profits for all. Historically, naphtha-based production in Asia was among the least competitive ethylene crackers globally. While some of the disadvantage was negated by value created through the sale of co-products (co-product credits), such credits were only helpful if there was ample demand for these co-products, and in recent years demand has been tepid at best. However, as a result of the collapse in the oil price in the past 24 months, the changes in cash costs have been very favorable to naphtha-based producers as costs have fallen by more than two-thirds. As a result, Asian naphtha-based production is no longer the highest-cost producer on the cost curve, disparagingly, that now falls to the Chinese coal-toolefins (CTO) producers. And it should come as no surprise to find that most of the projects canceled in recent years were CTO-based capacities. Due to this newfound cost advantage, Asiabased naphtha crackers are expected to report strong margins over our forecast horizon. As demand for co-products improves also, these naphtha crackers should benefit from higher returns as the supply-demand balance tightens. Among the various winners of this structural change in Asia are the market leaders LG Chem, Siam Cement, Reliance Industries and the Formosa Plastics Group. Exhibit 41. Global capacity expansion breakdown by region (ktpa) E 2017E 2018E 2019E 2020E China , Middle East 1,006 1, SE Asia ,116 India 15 1,017 1, NE Asia (excl China) , Europe & central Americas 419 1,034 3,666 3,493 3, Others World incremental 2,388 2,963 7,297 6,171 6,162 3,333 supply Incremental demand 5,231 3,724 4,764 5,120 4,707 5,456 Balance -2, ,533 +1,051 +1,456-2,123 Source: Deutsche Bank estimates, IHS Chemicals. Cement a business driven by domestic consumption Unlike petrochemicals or the metals processing industries, whose prices and margins tend to be global in nature, cement is a business more about local opportunities, local pricing and oligopolistic behavior in a narrow market. Geography matters, and the local nature of the business is one of the features that distinguishes cement from other cyclical commodities, and makes it more attractive particularly for investors looking for growth driven by domestic consumption rather than export opportunities. The cement industry will also benefit from lower energy costs, through lower electricity tariffs, coal prices or the cost of transportation fuels. Exhibit 42. Cash cost decline for naphtha-based producers (USD/ton) 1,600 1,200 1,350 1, Saudi ethane Iran ethane US ethane China coal to olefin Asia naphtha Europe naphtha feed Source: Deutsche Bank estimates, IHS Chemicals. Riding a new wave Emerging Markets: The new normal 41

42 Commodities: How to profit in a subdued oil price world? Exhibit 43. Competitive forces analysis Cement Industry Entrants: LOW Generally few new producers in the market because of high capex requirements and the need to meet environmental/planning regimes. However, there is considerable global capacity additions by existing manufacturers. Bargaining power of Suppliers: HIGH Most cement companies have limestone and shale quarries and now operate regional, continental and global sourcing programmes where appropriate. However, energy prices are largely determined on world markets. Competitive rivalry in Industry: MEDIUM The Cement industry is very localized because of high transportation costs. This can give small (existing) players relatively strong influence. However, industry consolidation in a capital intensive market with rising energy costs is likely to continue the strong consolidation trend seen over the last decade. Consolidation is unevenly advanced throughout the world but is the highest in developed markets and is accelerating rapidly in emerging markets. Bargaining power of Buyers: LOW Cement prices are largely determined by supply/ demand conditions on a local level and are influenced by the (vertically) integrated structure of the market. Threat of Substitutes: LOW Cement is key in most infrastructure and construction work. Cement has existed since the pharaohs with no effective substitute. Source: UBS, Michael Porter Each country has its own unique market structure, price caps, stages of development and point in the market s life-cycle. These factors all play a part in determining the sustainable growth, profitability, and the potential risks the cement player faces in their market. In Asia, we see the following: Most favorable: Indonesia > India > Thailand Least favorable: China > Taiwan Based on the attractiveness of each market, rate of growth and the longevity of that growth, we rank Indonesia and India as the two countries with the highest expansion potential. Indonesia ranks slightly ahead of India largely on market structure and higher margins. Thailand, though oversupplied, is a market that could see some recovery in the outer years and also for its potential to make inroads into the neighboring markets of Cambodia, Laos and Myanmar. China ranks last in our universe as the key markets are seeing some oversupply, made worse by the fact that some of those regions are fast approaching a major negative inflection in the demand growth cycle (i.e., past the peak of cement consumption intensity). Cement volume growth is closely linked to economic development. With the Emerging Markets largely in the earlier stages of economic development, cement consumption is expected to grow much faster. The key drivers are: higher population growth, younger population, trend to urbanization/migration, larger infrastructure needs (roads, irrigation, water/sewage, power etc.), housing needs and foreign direct investment (FDI). As can be observed below, Indonesia and India are still in the early growth phase of development the markets here have few cement players and are on the cusp of years of double-digit demand growth once urbanization kicks in. Thailand is a bit further along in its market development, in a phase where profitability can see wild swings as capacity additions tend to be quite lumpy and the industry can go from undersupplied to oversupplied and back again in a relatively short space of time. China however is perhaps already deep into the danger zone, the point where its urbanization has peaked (certainly for a number of coastal cities, perhaps not yet for some inland cities) and demand is expected to drop off. 42 Riding a new wave Emerging Markets: The new normal

43 Commodities: How to profit in a subdued oil price world? Exhibit 44. Development phase Top 40 Cement Markets 100% Argentina % Urban Population 80% 60% 40% 20% Brazil Canada France United States Saudi Arabia Mexico Colombia Jordan United Kingdom Russia Germany Iran Ukraine Iraq Malaysia Turkey Japan Algeria Poland Portugal Morocco Romania 'Danger Zone' Ghana Syria Replacement Philippines Nigeria China Indonesia Egypt Pakistan India Vietnam Thailand Urbanisation Tanzania Kenya Early Growth Spain Italy Austria Greece 0% 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 Source: Bernstein analysis. Cumulative Cement Demand per Capita kg Similarly, Latin American countries generally also reveal low cement consumption per capita data, and, while they are relatively more advanced on the urbanization process than some Asian countries, the need for more adequate housing and especially ongoing infrastructure investments should continue supporting cement demand growth in the region for the following years. Currently, the residential segment accounts for more than 50% of the overall cement demand for most Latin American countries, with public and non-residential demand accounting for the remainder. Looking forward, and considering the still very-underdeveloped infrastructure in most countries in Latin America, we expect large infrastructure programs to be one of the main drivers of cement consumption in the region. Exhibit 45. The five phases in an industry's development and their corresponding profitability 15 years 4 years ~ 10 years 60% Nigeria Indonesia Pakistan Kenya India Early Growth Russia South Africa Brazil Thailand Sweet Spot Algeria Morocco Mexico Poland Egypt Australia Jordan Malaysia Turkey China 'Danger Zone' Taiwan Italy Greece Spain Germany Japan Mature Oversupplied South Korea Portugal France USA UK Canada Mature Restructured UAE 50% 40% 30% 20% 10% 0% Normalized EBITDA Margin Sources: Cembureau, ICR, UN, corporate reports and Bernstein analysis, Data as of end Riding a new wave Emerging Markets: The new normal 43

44 Commodities: How to profit in a subdued oil price world? Exhibit 46. Latin American countries rank poorly on infrastructure Infrastructure Ranking While infrastructure still represents only a small share of total cement demand Cement consumption by segment (%) Germany France UK US Italy Panama China Chile Mexico Brazil Colombia Peru Argentina Nicaragua Honduras Bolivia Paraguay Venezuela Brazil Mexico Colombia LatAm US Residential Public Non-residential Source: World Economic Forum Global Competitiveness report (total number of countries = 144). Source: Industry sources, Company data, Morgan Stanley Research. In our view, this environment should provide good opportunities for the cement industry in Latin America, especially for high-quality, market leader players (e.g. Cemex, Cementos Argos). Conclusion In a subdued oil price world, we continue to see opportunities for a select number of industry players. In upstream oil, we see equities of Russian oil companies outperforming their international peers on comparative low-cost advantages in both production and reserve replacement. Downstream, we favor the Asian petrochemicals sector, a key beneficiary of a low oil price through lower input and processing costs, and a sector where the supply-demand dynamics is expected to be in favor of the producers over the near term. Cement is another sector where margins should benefit through the capping of key variable costs in a benign oil price environment. Although, we note that with cement, the opportunities are driven more by the local environment than by the global market. 44 Riding a new wave Emerging Markets: The new normal

45 Chapter 7 Real estate: Rising income, urbanization to lift these Asian countries Riding a new wave Emerging Markets: The new normal 45

46 Real estate: Rising income, urbanization to lift these Asian countries Theoretically, real estate may seem relatively unattractive in China due to a period of low inflation. However, China property is differentiated from other mature markets with three core themes that drive property companies investments in the mid-term as China s real estate market evolves: Urbanization According to the State Council, China s urbanization would focus more on the development of big city clusters each cluster with bigger cities (like Tier-2 and Tier-3 cities) linking with smaller cities and towns (like Tier-4 cities and institutionalized towns) via modern infrastructure (including transportation and information networks). The Central government is now actively looking for ways to develop new, big city clusters in the central, western, and northern part of China. Several provinces in the northern, northeast and Midwest are below the national average. With these, we now see strong development potential for Tier-2 and top Tier-3 cities, especially in central, western, and northern China, in the next 10 to 15 years. Taking five key clusters in China as an example, including Chengdu & Chongqing/Guangzhou, Shenzhen & Foshan/Shanghai, Nanjing & Hangzhou/Beijing, Tianjin and Hebei/ Greater Wuhan, we expect residential GFA (gross floor area) to hit 286msm (million square meters) by 2020 (a 4% CAGR). In 2014, the top five metro areas achieved c.226msm residential GFA sales (c. 21% of the country's total) and Rmb2.16trn total residential sales (35% of total) for the five core metropolitan areas (i.e., Shanghai-Nanjing-Hangzhou; Beijing-Tianjin-Hebei, Guangzhou-Shenzhen-Foshan; Chengdu-Chongqing; Greater Wuhan, according to Citi Research. Assuming that urbanization levels will reach about 70% in 2030 in these five clusters, we may see 7.5m in new population or 2.5m new households (three people per household) a year in these five metropolitan areas. Conservatively, if we assume only 10% of the newly urbanized residents buy a flat, we would have new demand of 250,000 units or 25msm every year. Including organic household formation, mainly from new marriages and upgraders, Citi Research estimated that housing demand in the five metro areas will reach around 300msm GFA by 2030E, implying a c. 3% CAGR (note that we only assumed a low 10% of newly urbanized dwellers will own property). Income growth While high-income countries of today have been highly urbanized for several decades, upper-middle-income countries have experienced the fastest pace of urbanization since For high-income countries, a majority (57%) of the population already lived in urban areas in 1950 (see above) and urbanization is expected to rise Exhibit 47. Urbanization rate (%) in key Chinese provinces 100% 75% 50% 25% 0% Shanghai Beijing Tianjin Guangdong Liaoning Zhejiang Jiangsu Fujian Inner Mon Chongqing Heilongjiang Jilin Hubei Shanxi Shandong Ningxia Shaanxi Hainan Jiangxi Qinghai Hunan Hebei Anhui Xinjiang Sichuan Guangxi Henan Yunnan Gansu Guizhou Tibet Urbanization rate Average China urbanization rate Source: UBS and CEIC estimates. 46 Riding a new wave Emerging Markets: The new normal

47 Real estate: Rising income, urbanization to lift these Asian countries Exhibit 48. Proportion urban by income groups, % 80% 60% 40% 20% 0% High-income countries Lower-middle-income countries Upper-middle-income countries Low-income countries Source: United Nations, Department of Economic and Social Affairs, Population Division, as of Jun from 80% today to 86% in 2050, according to United Nations, Department of Economic and Social Affairs, Population Division. By contrast, in today's upper-middle-income countries, only 20% of the population lived in urban areas in 1950, but these countries urbanized rapidly and are now 63% urban. This percentage is expected to rise to 79% urban by 2050, according to the United Nations, Department of Economic and Social Affairs, Population Division. We believe countries such as China, where income growth rose rapidly in the past decades in the middle income and upper income segments, will experience both rapid urbanization and rapid growth of gross national income in the next 10 to 20 years. Market consolidation More interestingly, Chinese developers that are exposed to new urbanized clusters will benefit from higher growth due to further market consolidation. Exhibit 49. Market share of top 10 developers in key countries in 2013 Average for all: 52% 100% Western Countries key cities: 44% average Asian Countries key cities: 61% average 75% 50% 25% 0% China Tier 1/2 cities Canada Top 10 cities (Toronto, Montreal, Vancouver etc) US Top 10 cities (NY, LA, Chicago, Houston, PL etc) UK Top 10 cities (London, Birmingham, Glasgow etc) Australia (Sydney, Melbourne, Brisbane, Perth etc) Indonesia (Jakarta, Surabaya, Bandung etc) Taiwan (Taipei, New Taipei, Kaohsiong, Taichung) Japan Top 10 cities (Tokyo, Osaka, Aichi, Kyoto etc) Singapore Korea (Seoul, Busan, Incheon, Daegu etc) HK Source: Citi Research. Riding a new wave Emerging Markets: The new normal 47

48 Real estate: Rising income, urbanization to lift these Asian countries Exhibit 50. China property market share of top 10 developers 25% 20% 15% 10% 5% 0% Source: Citi Research. By 2020 (estimated urbanization rate 60%), the top 10 property companies market share could grow to 45% in top five metro areas and five regional hubs (17% are in other cities). We see the nationwide market share of the top 10 developers being around 35% by As such, we believe the top-10 developers can grow their aggregated sales of RMB 1,069 billion in 2014 to RMB 2,619 billion in 2020E, implying around 16.1% CAGR. Population growth brings real estate opportunities to some ASEAN countries The ASEAN Economic Community (AEC) represents ASEAN's vision of regional economic integration, through establishing a single market supporting the free flow of goods and services, including labor. The UN estimates that this Exhibit 51. Urbanisation rate (%) rising across ASEAN Singapore Brunei Darussalam Malaysia Indonesia Thailand Philippines Lao People's Democratic Republic Myanmar Viet Nam Cambodia 0% 20% 40% 60% 80% 100% Source: United Nations, World Urbanization Prospects: The 2014 Revision, June Riding a new wave Emerging Markets: The new normal

49 Real estate: Rising income, urbanization to lift these Asian countries regional integration generates a huge market, to the tune of over 600 million people, with a combined GDP of some USD 2 trillion. When fully implemented and operational, the AEC will have the potential to create 14 million new jobs from 2015 to 2025 and increase the annual growth rate in the region to 7.1% in 2025, according to a 2014 report by the International Labor Organization and the Asian Development Bank. With the potential integration, more opportunities will be created in key cities within ASEAN, spurring faster labor growth and demand for housing. With the exception of Hong Kong and Singapore, Asian countries' urbanization levels are still below the global average of 55%. Today, the most urbanized regions include Northern America (82% living in urban areas in 2014), Latin America and the Caribbean (80%), and Europe (73%). This is in contrast to 48% in Asia and 47% in Southeast Asia. Asean regions are expected to urbanize further over the coming decades with an additional eight million people per year making the rural to urban migration across SEA from 2015 to This will help push urbanization for the region as a whole to above 50%, from 47% today. Based on the World Population data reported by the United Nations Population Division, the population of ASEAN will increase from 633 million people in 2015 to 717 million in 2030 and 741 million people in 2035, a rate of 0.85% per annum. In 2030, three countries in ASEAN will have a population of over 100 million people: Indonesia (284 million); Philippines (127 million) and Viet Nam (103 million). These countries, together with Laos and Malaysia, have a young population that will support housing demand going forward. Indonesia stands out given high urban population growth (2.7% growth in the past 5 years, close to China s 2.9%). Assuming the average size of a household shrinks from 4.0 in 2015 to 3.8 by 2018 (continuing the past trend, according to UN estimates), the urban household CAGR for the next three years will be at 4.1%, the highest in the region. The Philippines also stands out given its high wealth growth (median disposable income per household has grown at 3.7% CAGR in the past five years, one of the highest in the region), Exhibit 52. Population forecast for ASEAN young population and the lowest urbanization rate in the region at 44.4%. Together with higher disposable income, these drivers will provide 3.1% upside to current urban household growth. Overall in ASEAN, urban cities population is likely to grow at a rate of 2-3%p.a over the next 10 years, and the growth rate will be faster for mega cities such as Manila, Cebu, Bangkok, Jakarta and Surabaya, among others. As such, housing demand in provincial capitals and higher tier cities will be well supported by urban population growth, higher disposal income and improving infrastructure. Avg. Annual Growth Rate Brunei Dar % Cambodia 15,087 15,978 16,799 17,509 18, % Indonesia 254, , , , , % Lao PDR 6,666 7,088 7,479 7,815 8, % Malaysia 30,916 33,271 35,549 37,783 39, % Myammar 50,305 52,115 53,669 54,934 55, % Phillippines 101, , , , , % Singapore 5,498 5,757 6,008 6,276 6, % Thailand 72,306 73,835 74,866 75,724 76, % Viet Nam 93,823 97, , , , % ASEAN 633, , , , , % Source: United Nations. Exhibit 53. Aging population percentage % of population higher than 65 years old Brunei Dar Cambodia Indonesia Lao PDR Malaysia Myammar Phillippines Singapore Thailand Viet Nam ASEAN 7.13% 8.49% 10.24% 12.26% 15.49% Source: United Nations. Riding a new wave Emerging Markets: The new normal 49

50 50 Riding a new wave Emerging Markets: The new normal

51 Chapter 8 The threat of globalization is reversing Riding a new wave Emerging Markets: The new normal 51