European Equity Strategy

European Equity Strategy 2017 year ahead – Refining the reflation rotation 01 December 2016 Unauthorized redistribution of this report is prohibited. This report is intended for [email protected] Key takeaways • 2017 - Reflation, Reversal, Rotation, Relief or Revolt. EPS to turn +ve but politics to remain a valuation overhang in H1. • Defensive vs Cyclical rotation at extreme levels. More balanced approach needed but look for another leg to cyclical trades. • O/w Media as quality cyclical and Oil. Stay cautious on UK domestic (Retail, Travel). Health, Utilities over Food & Bev. 2017 – A year of cross currents, nimble investors required Recovery (positive but moderate in our view) and Rotation go hand in hand - we think that the pace of the rotation has to moderate. ECB reversal on QE is a risk and tapering because the ability or willingness to do QE fades would likely cause a setback. Investors will demand a premium for political risk until we get clarity on populist Revolt or policy Relief in France and elsewhere. Like 2016 investors will need to trade the ranges. High single digit upside - politics likely to weigh near term A valuation overhang remains in Europe vs other DM. We see a return to positive EPS growth (+7%) in Europe for the first time since 2014, driven by higher global GDP growth Resources recovery, capex discipline and FX. +7% growth implies less downgrades than usual (10% is the average). Base case upside in high single digits (c9% total return) but politics may mean market highs are more likely achieved in H2. Modestly higher yields and higher equities compatible Equities can continue to perform with rising rates – the key is that inflation breakevens are not falling. However, a more aggressive bond sell-off taking Treasury yields to 3% or higher would undermine EM, the growth outlook, peripheral spreads and risky assets. Reflation rotation stretched – refining our approach Rotation has been extreme (>6SD move in Def vs Cyclicals). Argues for a moderation in returns and a more balanced approach to sector allocation. Look for another leg to cyclical trades in the New Year. Sector valuations have also moved a long way already. Cautious on domestic UK exposure – Brexit still to bite The full impact of sterling weakness on the UK consumer environment is yet to be felt and Brexit negotiations are likely to drive further uncertainty and FX volatility. Structural issues add to our concerns in Retail and Travel & Leisure (both underweight). O/w Oil, Health, Utilities, Media; u/w Food & Beverage An OPEC cut and higher oil would make Oil’s high DY sustainable. Healthcare is too cheap vs an improving sector growth outlook and 2017 is a key year for pipeline news. Food & Beverage still seems the least attractive Defensive on valuation, positioning. We move overweight Media, a quality cyclical that has lagged and seen valuations de-rate. >> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions. BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 37 to 38. Analyst Certification on page 36. 11690765 Timestamp: 01 December 2016 12:00AM EST Equity Strategy Europe Ronan Carr, CFA >> European Equity Strategist MLI (UK) +44 20 7996 3292 [email protected] James Barty >> Investment Strategist MLI (UK) +44 20 7996 3291 [email protected] Tommy Ricketts >> European Equity Strategist MLI (UK) +44 20 7996 3294 [email protected] Refining the reflation rotation 2017 is likely to have a number of cross currents as themes. Recovery (we look a modest acceleration in both growth and inflation) and Rotation go hand in hand. On the basis of our central forecasts for growth, inflation and rates and given the moves in the market already we think that the pace of the rotation has to moderate. (In-line with that we recently downgraded of banks and miners). Reversal refers to the ECB. Our economists are not yet convinced that the ECB will start to unwind loose policy 2017 but the probability is increasing. An ECB that tapers because growth and inflation are improving would be supportive for markets, notably banks. But tapering because the ability or willingness to do QE fades would likely cause a setback. Relief or Revolt relates to European politics. Will Europe follow the route to populism (revolt from the voters) or will we find relief for the markets by the end of 2017 from a Fillon/Merkel duo being in charge of the Euro area’s two largest economies. We think investors will demand a higher risk premium until the French Elections in May 2017 Valuation are reasonable at 14x PE but Europe is cheap on a relative basis and the valuation overhang remains evident in the region’s equity risk premium, which implies 11% upside to get back to 5-year average levels. We see a return to positive EPS growth (+7%) in Europe for the first time since 2014, as 3.5% global GDP growth should deliver positive earnings growth (supported by Resources recovery, capex discipline and FX. +7% growth implies less downgrades than usual (10% is the average). Bond yields and equities – stable/higher inflation breakevens are key. Equities can continue to perform in an environment of higher rates – the key is that inflation breakevens are not falling. However, a more aggressive bond sell-off taking Treasury yields to 3% or higher would undermine EM, the growth outlook and risky assets. The rotation out of bond proxies and Defensives into Financials and Cyclicals has moved to extreme levels: relative performance of Financials / Cyclicals versus Defensives rose over 6SD in 10-14 months. Technical metrics are at historical extremes, arguing for a moderation in relative returns and a more balanced approach to sector allocation is justified right now. Look for another leg to cyclical trades in the New Year. Sectors have also moved a long way already from a valuation perspective. Financials are now trading around median relative valuation levels. Healthcare PE relative is at the bottom of the historical range and Utilities relative PE is also close to the prior low hit in 2013. Food & Beverage still commands a large premium and PErelative is 6-10% above the 2010 / 2014 lows. We remain cautious on domestic UK exposure. The full impact of sterling weakness on the UK consumer environment is yet to be felt and Brexit negotiations are likely to drive further uncertainty and FX volatility in our view. Structural issues add to our concerns in Retail and Travel & Leisure (both underweight). Overweight Oil, Healthcare, Utilities, Media; underweight Food & Beverage. If OPEC cuts production and oil recovers up to the high $50s per barrel, Oil sector EPS and cash flows can recover significantly and make the highest DY in market (6%) look sustainable. Healthcare we believe is too cheap relative to an improving sector growth outlook. 2017 will be an important year for newsflow on key pipeline drugs. Evidence of success can drive a re-rating independent of macro. Despite the recent sell-off, among defensives and bond proxies Food & Beverage still seems the least attractive. Valuations are among the most expensive in the market and overweight positioning has not corrected materially yet. We move overweight Media, a wuality cyclical that has lagged badly and seen valuations de-rate. 2 European Equity Strategy | 01 December 2016 Key charts Chart 1: Synchronised rise in leading indicators globally augurs well for earnings recovery – especially if PMIs kick on to or above mid-50s 65 60 55 50 45 40 35 ISM / Euro PMI manuf avg (advanced 9m) 30 MSCI Europe EPS € (trailing yoy, RHS) 01/98 01/01 01/04 01/07 01/10 01/13 01/16 Source: BofA Merrill Lynch Global Research, Datastream, IBES 60 40 20 0 -20 -40 -60 Chart 2: Modestly higher yields and higher equities compatible – Rising inflation breakevens the key for equities 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 Stoxx 600 4-week returns vs 4-week change in real yields / inflation breakevens (since 2009) Bund real >+0, b/even +ve Source: BofA Merrill Lynch Global Research, Bloomberg Bund real >+0, b/even -ve Chart 3: Cyclicals vs Defensives trade now looks very stretched 4 3 2 1 0 -1 -2 -3 -4 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13 Cyclicals vs Defensives - relative price vs 52wk average (SD) Source: BofA Merrill Lynch Global Research, Bloomberg Chart 5: Financials valuations have recovered significantly relative to the move in bond yields – relative PE back around average levels 0.90 3.5 0.85 0.80 0.75 0.70 0.65 Banks / Insurance PE-rel 0.60 German 10y (RHS) 01/10 01/11 01/12 01/13 01/14 01/15 01/16 Source: BofA Merrill Lynch Global Research, Datastream, IBES 3 2.5 2 1.5 1 0.5 0 -0.5 Chart 4: Likewise Financials vs Defensives: -2.5SD to +2.5SD post-Brexit 4 2 0 -2 -4 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13 Financials vs Defensives - relative price vs 52wk average (SD) Source: Re BofA Merrill Lynch Global Research, Bloomberg place this text Chart 6: Rapid relative de-rating for Staples – relative PE for Food & Beverage still 6-10% above 2010 / 2014 levels 1.70 -1 1.60 1.50 1.40 1.30 1.20 PE-relative FOOD & BEV 1.10 German 10y (RHS, inverted) 01/10 01/11 01/12 01/13 01/14 01/15 01/16 Source: BofA Merrill Lynch Global Research, Datastream, IBES 0 1 2 3 4 European Equity Strategy | 01 December 2016 3 Lessons from 2016 The old joke is that Year Aheads are frequently out of date by the end of year they are written in. There is a real danger of that this year given the speed which things have moved since Brexit and more recently the US election. The two charts below show that Financials and Cyclicals have clawed back around 2/3 of their underperformance vs Defensives. Of course it depends how you frame the question since we have included Utilities and Telecoms in the defensive basket. But when we downgraded Banks 10 days or so ago they had outperformed Food and Beverage by ~50% since the lows of early July. Whichever way you cut it some of these moves have been extreme. Chart 7: The moves since Brexit in both Financials… 0.85 0.80 0.75 0.70 0.65 0.60 0.55 0.50 Financials vs Defensives relative 0.45 01/10 01/11 01/12 01/13 01/14 01/15 01/16 Source: Bloomberg Chart 8: …and Cyclicals relative to Defensives has been dramatic 1.45 1.35 1.25 1.15 1.05 0.95 Cyclicals vs Defensives relative 0.85 0.75 01/10 01/11 01/12 01/13 01/14 01/15 01/16 Source: Bloomberg Moreover, in 2016 we doubt that even if investors had known the results of key events that they would necessarily have got the reaction in markets right. As we joked in our Cross Asset year ahead you needed not so much a crystal ball as a time machine to have got things completely right this year. Aside from Brexit and Donald Trump winning the US election it is easy to forget that in February we were worrying about a US recession and deflation. US 5Y5Y forward breakeven inflation rates actually troughed at 1.8% at that point. Four months later we were worrying about the deflationary impact of Brexit. Now we are thinking about the reflation under a Trump Presidency. Chart 9: US 5Y5Y forward inflation troughed in February 3.3 3.1 2.9 2.7 2.5 2.3 2.1 1.9 US 5y5y fwd inflation swap 1.7 Chart 10: At the same time as Basic Resources 1.7 Stoxx Basic Resources Price Relative 1.5 1.3 1.1 0.9 0.7 0.5 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Source: Bloomberg Source: Bloomberg The panic in markets in early February actually presented a perfect buying opportunity for reflationary assets. Miners was a sector truly loathed by investors of all colours at the start of the year with many thinking that some of the big players might even go bust. If there is one key conclusion from all of this it is do not tie yourself to a view. We 4 European Equity Strategy | 01 December 2016 were underweight at the start of the year too and missed the lows. We recognized we were wrong and closed our underweight and while it took us a while but we eventually managed to go overweight in September. The lesson of that is that themes are great, but when the facts change strategists and investors have to change their minds. Chart 11: Cyclicals vs Defensives: from -3.5SD to +3.2SD in 14 months 4 3 2 1 0 -1 -2 -3 -4 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13 Cyclicals vs Defensives - relative price vs 52wk average (SD) Source: BofA Merrill Lynch Global Research, Bloomberg Chart 12: Financials vs Defensives: -2.5SD to +2.5SD post Brexit 4 3 2 1 0 -1 -2 -3 -4 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13 Financials vs Defensives - relative price vs 52wk average (SD) Source: Re BofA Merrill Lynch Global Research, Bloomberg place this text In fact your best guide to this year was to buy something when it has oversold, underowned and unloved, like Miners and Emerging Markets in February, Banks in July, the Nikkei the day of the US election and sell when the opposite e.g. bonds and defensive equities shortly after Brexit. Our CTI models did actually pick up a number of those events as the table below shows. It also got picked up by our standard deviation analysis. We acted on some but not all of these readings. The lesson, with the benefit of hindsight, is to pay more attention to them. Indeed, our recent decision to downgrade both Banks and Basic Resources reflected very high readings on our models. Table 1: Reflation rotation very stretched on our CTIs post-Trump Asset 11/11/2016 10/11/2016 09/11/2016 EUR/GBP -46 -44 -12 German 10y Bonds 66 61 24 US 10y Bonds 96 96 93 Stoxx Banks 80 71 0 Stoxx Basic Resources 92 93 92 Stoxx Food & Beverages -84 -96 -54 Stoxx Insurance 67 64 23 Stoxx Personal & Household Goods -34 -75 -7 Stoxx Utilities -92 -94 -19 Relative CTI Relative Stoxx Banks 86 87 50 Relative Stoxx Basic Resources 100 100 99 Relative Stoxx Food & Beverages -93 -93 -89 Relative Stoxx Insurance 92 91 76 Relative Stoxx Media -34 -77 -87 Relative Stoxx Pers&Hhold Goods -92 -94 -75 Relative Stoxx Technology -80 -74 -55 Relative Stoxx Telecom -91 -92 -28 Relative Stoxx Utilities -82 -92 -59 Source: BofA Merrill Lynch Global Research, Bloomberg Table 2: While opposite true immediately post-Brexit Asset 29/06/2016 28/06/2016 27/06/2016 Relative Stoxx Autos -95 -39 -9 Relative Stoxx Banks -80 -83 -86 Relative Stoxx Basic Resources 21 3 0 Relative Stoxx Chemicals 2 19 40 Relative Stoxx Construction & Materials -10 -36 -71 Relative Stoxx Financial Services -91 -91 -92 Relative Stoxx Food & Beverages 60 78 82 Relative Stoxx Healthcare 88 88 88 Relative Stoxx Industrial Goods & Services -47 -35 -44 Relative Stoxx Insurance -87 -94 -94 Relative Stoxx Media -6 -13 -35 Relative Stoxx Oil & Gas 93 86 91 Relative Stoxx Personal & Household Goods 57 58 70 Relative Stoxx Retail -63 -81 -75 Relative Stoxx Technology 0 0 0 Relative Stoxx Telecom 3 0 -16 Relative Stoxx Travel & Leisure -98 -100 -100 Relative Stoxx Utilities 65 6 2 Source: BofA Merrill Lynch Global Research, Bloomberg We think 2017 is another year where investors will need to be nimble. Markets have responded enthusiastically to a prospective Trump Presidency but as the above charts suggest we may well have discounted much of it. That is also supported by our fixed income and FX forecasts, which suggest much has already been priced in. In addition we have political risk starting with next weekend’s Italian referendum stretching to the German elections in Autumn 2017. In the middle we have the crucial French elections. A European Equity Strategy | 01 December 2016 5 Marine Le Pen victory could bring into question both the future of the EU and also the euro, should the polls be close it could make the uncertainty and market moves around Brexit look like a walk in the park. 2017 – Reflation, Reversal, Rotation, Relief or Revolt? 2017 is likely to have a number of cross currents as themes. Recovery and Rotation go hand in hand. The stronger the recovery the more yields can rise the more we can see the rotation extend. Should investors become concerned that the recovery is stalling or that yields are peaking the rotation would likely stall potentially even reverse. Reversal refers to the ECB. Our economists are not yet convinced that the ECB will start to unravel some of its easing measures in 2017 but they do expect the debate to be a vigorous one within the ECB. For the first time Gilles Moec thinks there is a chance that the ECB will indeed choose to taper. Relief or Revolt relates to the French election. Will Europe follow the UK and US lead of 2016 and go down the route of populism (revolt from the voters) or will we find relief for the markets if by the end of 2017 from a Fillon/Merkel duo being in charge of the two largest economies in the Euro Area. Recovery – the world looks a better place going into 2017 Reflation has been the big theme of the second half of the year. As we had noted in previous publications there had been something of an improvement in the global growth picture emerging even before the US election. It started with Emerging Market growth, which our GEMScycle has been showing to be accelerating for some months, but seems to have spread to other parts of the developing world. US GDP for Q3 has just printed a revised 3.2%, with a number of indicators, such as ISM’s, PMI’s and consumer confidence pointing to a solid Q4 to follow. That quarter is currently tracking at 3.6% according to the Atlanta Fed. Chart 13: Eurozone PMI’s have picked up of late… 60.0 55.0 50.0 45.0 40.0 EA Services PMI EA Manufacturing PMI Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16 Source: Markit Chart 14: US Consumer Confidence now at post-GFC highs 120 100 80 60 40 20 Source: Bloomberg US Consumer Confidence… Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 The Euro Area too is showing signs of improvement with the latest manufacturing PMIs back to their best since early 2014 with other national surveys, such as Ifo pointing in the same direction. The composite PMI is back close to the year highs too. The UK numbers continue to surprise on the upside too for the moment. Our economists are also upbeat on Japan with growth expected to accelerate next year as the fiscal stimulus kicks in. Accordingly our economists expect growth to rise from 3% this year to 3.5% in 2017 and 3.8% in 2018. That acceleration in growth is despite a slightly slower US economy in the first half of the year as a higher USD and interest rates dampen growth before the fiscal stimulus kicks in. With growth firming and oil prices expected to be higher inflation is also expected to pick up through 2017 and 2018 to 2.8% and 3% respectively. At this stage it is worth noting that this is a modest acceleration in both growth and inflation. 6 European Equity Strategy | 01 December 2016 The Fed is accordingly expected to proceed cautiously at least initially. In part for that reason our fixed income and FX strategists have only a modest further increase in bond yields and the USD in their forecasts for next year. They project 10Y US Treasuries rising to 2.65% and the USD to 1.02 vs the EUR. The dollar is expected to strengthen more aggressively against both the GBP and the JPY, but even so the gain in the currency overall has been frontloaded into 2016. Our economists and strategists are cautious partly because the fiscal stimulus is expected to have only a modest impact on growth, at around 0.5% of GDP. That is based on the assumption that some of the proposals will get watered down and that the tax cuts have a relatively low fiscal multiplier. Our US economists think that should the fiscal stimulus be larger and more effective (for which read more infrastructure) then US growth could surprise on the upside to around 3% in 2017 and 3.5% in 2018. That in turn would mean a more aggressive Fed and in all likelihood a bigger rise in yields and the USD. Chart 15: BofAML sees GDP accelerating into 2018… Global GDP growth % DM GDP growth % EM GDP growth % 4.7 5.1 3.2 4.1 3.1 4.1 3.5 3.8 2.1 1.5 1.7 1.9 Chart 16: …with inflation picking up too Global CPI inflation % DM CPI inflation % EM CPI inflation % 4.2 3.6 3.6 3.8 2.5 2.4 2.8 3 1.7 1.8 0.7 0.3 2015 2016F 2017F 2018F Source: BofA Merrill Lynch Global Research 2015 2016F 2017F 2018F Source: BofA Merrill Lynch Global Research Reversal: There is good taper and bad taper The outcome of that would likely affect ECB behaviour too. Our central expectation is for Euro Area growth of around 1 ½% and inflation nudging only modestly higher. A much more robust global economy and a stronger USD (presumably weaker EUR) would likely put upward pressure on both of those. Indeed, in such an environment it is not impossible to think of 10Y Treasuries pushing through 3% and the USD breaking parity against the EUR. That in turn would increase the pressure on the ECB to start to reverse its very loose monetary policy stance. Tapering would then become much more likely. It would likely push European bond yields higher too, certainly above the 65bp forecast for Bund yields at the end of 2017. An ECB that tapers because growth and inflation are improving would not be a bad thing for markets. Frankly for some parts of the market, notably banks, anything which gets the ECB away from its current policy stance back towards normality is a positive. Indeed, the prospect of negative interest rates being reversed is the kind of thing which Alastair Ryan (our banks strategist) lies awake at night dreaming of ( see European Banks Strategy: repressed). But and it is a big but, if the ECB chooses to taper because it is running out of options or the ability to do QE that is not a good thing. Some of the hawks on the ECB would choose to taper at the first opportunity because they never really liked the idea of QE in the first place. A tapering at next week’s meeting even if it is couched in terms of doing less for longer would not be good news for equity markets. European Equity Strategy | 01 December 2016 7 Rotation – more to go but it has to be more gradual On the basis of our central forecasts for growth, inflation and rates and given the moves in the market already we think that the pace of the rotation has to moderate. After all if we are to see another 30-40 bp of yield increase in the US between now and H2 2017 having already seen more than 90bp since the summer, it has to slow. That view combined with the readings from our models lay behind our recent downgrades of banks and miners. That is not to say that the rotation is finished. If bond yields truly have turned than some of the more expensive defensives likely have to derate further. The bull market in those stocks has simply lasted too long for that not to be the case. In addition while there have been significant moves in positioning in terms of cutting underweights in areas like Banks and Basic Resources and hedge fund positioning has probably moved faster still, we do not believe that positioning has completely turned around. Looking at both the Fund Manager Survey and our own internal data we think there are still legacy underweights in cyclical areas and legacy overweights in defensives, particularly quality defensives. That argues for another leg in the rotation trade. Nevertheless, it suggests to us that a more balanced approach is justified right now. We are still overweight oil, but little else in the cyclical space, so today we add Media. We are still underweight Food & Beverage but against that we are overweight Healthcare and Utilities. Relief or revolt – Eurozone politics in focus in 2017 We think it likely investors will demand a higher risk premium until the French Elections in May 2017 given the likelihood that Marine Le Pen will make to the second round of voting (according to polls). A Le Pen victory could likely bring the future of the EU and the Euro into question as she has talked about France withdrawing from both. That in turn has arguably the potential to be even more of an earthquake for the world’s financial markets. Our central case is that centre right President is elected in France (with Francois Fillon now the official Republican candidate) and Merkel is returned at the head of a coalition government in Germany now that she has indicated she will stand for re-election. Until the French vote though we suspect investors will be cautious about European markets. Were this to be the case then we think there may well be room for a significant relief rally in European assets. We have more on this, including a calendar, in our section on Eurozone politics. Decent valuations but not compelling Headline PE multiples do not screen as particularly cheap for European equities but are also not excessively expensive. In fact the current forward PE on MSCI Europe at 14.1x is right in-line with the average since 1987. The most recent high in PE multiples was over 16.5x at the April 2015 market highs. However, more recently the market has traded in a fairly tight range around 14-15.5x PE, with some fleeting falls to 13x around the market lows in February 2016 and at the time of the Brexit referendum. At the current multiple we see valuations as quite reasonable therefore. Our index target assumes some multiple expansion back to 15x, which we think is quite achievable under our base case assumptions. 8 European Equity Strategy | 01 December 2016 Chart 17: MSCI Europe forward PE in-line with 30-year average at 14.1x… 30 MSCI Europe PE 12m fwd 25 20 15 10 5 12/87 12/91 12/95 12/99 12/03 12/07 12/11 12/15 Source: BofA Merrill Lynch Global Research, Datastream, IBES Chart 18: …but at lower end of 13-15.5x PE range of last 15 months 17.0 16.0 15.0 14.0 13.0 MSCI Europe PE 12m fwd 12.0 01/14 07/14 01/15 07/15 01/16 07/16 Source: BofA Merrill Lynch Global Research, Datastream, IBES Relative attractiveness of Europe depends on EPS recovery in medium-term. Moving to relative valuations, European equities screen somewhat cheap vs their DM peers. However, the medium-term bull case for Europe is far more a function of potential earnings and ROE recovery rather than significant undervaluation. Europe’s valuation discount to the US is at multi decade wides on PBV (over 40%) but that in turn reflects Europe’s significant underperformance on EPS growth and ROE. Trailing ROE for MSCI Europe is just 8% (at historical trough levels). That is nearly 5pp below MSCI USA compared to a 3pp gap on average historically and close to the widest spreads since the mid-1990s. Europe vs US relative PE 7% below average. Based on PE, Europe nevertheless trades cheap relative to the US. The PE discount at 18% is 7% wider than the 20 year average and relative PE is at the lowest level since 2012. So while a sustained reversal in the underperformance of Europe versus the US would over time have to be driven by a recovery in relative profitability we do see current valuations reflecting a discount perhaps for political reasons (Brexit, upcoming elections). Chart 19: Europe vs US: modest PE discount but cheap on rel. PBV 1.10 Relative PBV (MSCI) 1.00 Relative PE (12m fwd, IBES) 0.90 0.80 0.70 0.60 0.50 06/96 06/99 06/02 06/05 06/08 06/11 06/14 Source: BofA Merrill Lynch Global Research, Datastream, MSCI, IBES Chart 20: European earnings and profitability significantly lag the US 20 18 16 14 12 10 8 MSCI USA - trailing ROE MSCI Europe - trailing ROE 6 06/96 06/99 06/02 06/05 06/08 06/11 06/14 Source: BofA Merrill Lynch Global Research, Datastream, MSCI The other metric that illustrates the valuation overhang in Europe is the risk premium. Our model calculates an implied cost of equity (CoE) for Europe as 6.8%, a little below the average since 1988 (7.2%) and last 10 years (8.4%). The model assumes the cost of equity is simply the cyclically adjusted earnings yield (calculated using a 5 year centred average EPS). We then compare this number to the German bund yield to estimate the implied equity risk premium (ERP). European Equity Strategy | 01 December 2016 9 Europe’s ERP on our model is 6.9% – down from the post-Brexit highs at 7.5% but still at a 70bp premium to the 3 and 5 year average for the ERP. That in turn implies a ~11% valuation haircut relative to 5-year average levels. These numbers also show that the recent rise in bond yields is modest relative to where cost of equity or ERP sits. We're quite far away from the level that bond yields would make ERP look expensive. Even with bund yields at 75bp (ie +50bp from here) it would only shift the ERP back to average levels (all else equal). Bond yields need to rise 150- 200bp to get to the expensive end of the range of last 6 years on ERP. Chart 21: Implied cost of equity (CoE) on our model in Europe is 6.9%, a little below the average since 1988 (7.2%) and last 10 years (8.4%). 16 14 12 10 8 Chart 22: Implied equity risk premium remains elevated: 6.7% ERP to bund yields vs 10-year average of 6.2% and recent high of 7.3%. 12 10 8 6 6 4 2 Implied cost of equity (%) 4 2 Equity Risk Premium (vs 10y Bund) 0 01/88 01/91 01/94 01/97 01/00 01/03 01/06 01/09 01/12 01/15 Source: BofA Merrill Lynch Global Research, Datastream, MSCI, IBES 0 10/06 09/08 08/10 08/12 07/14 06/16 Source: BofA Merrill Lynch Global Research, Datastream, MSCI, IBES Europe cost of equity higher than long-run average compared to US. Europe also compares favourably on a relative basis against the US equity market in this framework. The implied CoE for the S&P500 on an equivalent model is 5.64%, which is now at an 11-year low and 130bp below the 10-year average. The implied ERP on that basis at 3.3% is also below average and not far off the lows from the past 10 years. Admittedly Europe did get significantly cheaper relative to the US during the GFC and the sovereign debt crisis. The cost of equity premium for MSCI Europe vs the S&P is 1.21%. That is a premium to the 30-year average of 0.72%. However it is below the average of the past 10 years – the spread peaked at over 4% in 2008 and at 2.7% in 2011 / 2012. Chart 23: Implied equity risk premium near 9-year lows in the US 9 8 7 6 5 4 3 2 S&P Equity Risk Premium (vs 10y UST) 1 0 10/06 09/08 08/10 08/12 07/14 06/16 Source: BofA Merrill Lynch Global Research, Datastream, MSCI, IBES Chart 24: Europe vs US implied cost of equity spread 5 Cost of equity spread Europe vs S&P 4 3 2 1 0 -1 -2 01/90 01/93 01/96 01/99 01/02 01/05 01/08 01/11 01/14 Source: BofA Merrill Lynch Global Research, Datastream, MSCI, IBES 10 European Equity Strategy | 01 December 2016 Earnings – a return to positive EPS growth in 2017 7% EPS growth in 2017 as global growth improves and Resources EPS recovers We think the earnings backdrop will be supportive in 2017 with a return to positive EPS growth in Europe for the first time since 2014 and with downside to consensus forecasts for the year ahead that are well below average. Our base case assumes +7% EPS growth in 2017 and 2018. With EPS broadly stagnant over the last 6 years, investors might justifiably ask what is different this time. We see several reasons to think mid to high single digit EPS growth is achievable next year. Chart 25: Earnings revisions are currently modestly positive 20% 10% 0% -10% -20% -30% -40% 12/00 12/03 12/06 12/09 12/12 12/15 Stoxx 600 EPS revisions ratio (4 wk avg) 13-week average Source: BofA Merrill Lynch Global Research, Datastream, IBES Chart 26: Broad based recovery in global growth (based on 29 PMIs) 100% 90% 80% 70% 60% 50% 40% 30% % PMIs > 50 % of PMIs increasing (last 3m) 20% 11/13 03/14 07/14 11/14 03/15 07/15 11/15 03/16 07/16 Source: BofA Merrill Lynch Global Research, Markit, Bloomberg Return to positive EPS growth feasible with global GDP at 3.5%... First, global growth is accelerating and on our economists’ base case forecasts global GDP growth will be 3.5%, the first materially above trend growth year since 2010. That is significant for European earnings given a reasonably tight relationship to global GDP growth. 3% represents the tipping point around which earnings growth tends to turn positive according to our regression model. At the BofAML forecast of 3.5% global GDP growth, 7% EPS growth is implied as likely by the same model. …as leading indicators point to a synchronized global recovery. What gives us confidence in this putative earnings recovery is the more synchronized nature of the current recovery. All major regions of the world are showing momentum in growth indicators for the first time in several years. One measure of the broad nature of the improvement is manufacturing PMI surveys. Of 29 Markit PMIs 83% are currently above 50, highest since August 2014. More importantly, 79% have improved over the last 3 months – higher than at any point in the last three years. Bull case of global GDP towards 4% would signal double digit EPS growth. To see a more bullish outcome for EPS we would need to see global GDP accelerating further. Based on our regression model, double digit EPS growth historically was consistent with global GDP growth above 3.8%. Under our bull case scenario for 2017, with say 4.0% global GDP growth, consensus EPS growth forecasts for +14% in Europe would become realistic. PMIs beyond 55 would suggest upside to base case. Significant further gains in leading indicators would be a signal that earnings growth could exceed our base case. Over the longer term EPS growth has followed manufacturing PMI surveys with a 9- month lag approximately (using an average of US and Eurozone). Historically readings above 55 were consistent with mid-teens EPS growth. The relationship has weakened in recent years as low interest rates and weaker commodity prices weighed on earnings in Financials and Resources. Nevertheless, in the last year of decent EPS growth in Europe in 2014 the PMIs peaked at 54 so we would look for upside to our base case EPS forecast should PMIs improve to the mid-50s level or beyond. European Equity Strategy | 01 December 2016 11 Chart 27: 3% Global GDP growth the tipping point for EPS Europe trailing EPS growth vs World GDP 50% 7% 40% 6% 30% 20% 5% 10% 4% 0% 3% -10% 2% -20% -30% 1% -40% 0% -50% -1% Q496 Q499 Q402 Q405 Q408 Q411 Q414 Q417 MSCI Europe 12m trail EPS (IBES) World GDP (right) Source: BofA Merrill Lynch Global Research, Datastream, IBES Chart 28: Synchronised rise in leading indicators globally augurs well for earnings recovery – especially if PMIs kick on to or above mid-50s 65 60 55 50 45 40 35 30 01/98 01/01 01/04 01/07 01/10 01/13 01/16 ISM / Euro PMI manuf avg (advanced 9m) MSCI Europe EPS € (trailing yoy, RHS) Source: BofA Merrill Lynch Global Research, Datastream, IBES 60 40 20 0 -20 -40 -60 Removal of the 3pp p.a. drag from Resources supports EPS outlook. Second, the Resources sectors in 2017 will likely provide a (strongly) positive contribution to market EPS, in turn reversing what has been the biggest headwind for several years. Over the last 3-5 years the Resources sectors provided a 2.5 percentage point drag on annualized market EPS growth. In 2016 Banks have been the other big drag on market earnings. While structural headwinds to profitability mean the contribution of Banks remains open to debate, consensus forecasts nevertheless imply a strong recovery in 2017 (driven in part by one-offs reversing). The important point is that the market ex-Banks and Resources has delivered modest but positive EPS growth – estimated at +5.5% for 2016. Hence, removing the drag from Oil and Mining makes high single digit growth achievable in our view. Chart 29: Resources a 2.5pp drag on market EPS growth in recent years Annualized EPS growth 4 3 2 1 0 3yr 5yr 10yr Chart 30: Capex discipline supportive to margin outlook Europe Ex-Financials: EBIT margins vs capex/depreciation 14% 12% 10% 8% 6% 100% 120% 140% 160% -1 -2 Stoxx 600 Market Ex-Resources Market Ex-Banks & Resources Source: BofA Merrill Lynch Global Research, Datastream, IBES 4% 1990 1994 1998 2002 2006 2010 2014 2018 EBIT / sales (LS, %) Forecast EBIT / sales (LS, %) Capex/depreciation - 2yma pushed 2y fwd (RS, %) Source: BofA Merrill Lynch Global Research, Factset 180% Margin upside, capex discipline and FX tailwind provide additional support. Third, profit margins in Europe are not elevated: in the bottom third of the historical range (since 2004) at the EBITDA level and about average at the net level. With some acceleration in the top-line as global growth and inflation pick up, there is scope for margins to improve. In addition, several years of relative capex discipline provide potential support for margin improvement over the next 1-2 years in corporate Europe. Over the longer term, we find that operating margins have tended to improve with a lag of one to two years, following a period of declining capex ratios. That is encouraging for 12 European Equity Strategy | 01 December 2016 the margin outlook into 2017-18, given Capex to depreciation for the Market Ex- Financials in 2015 hit its lowest level since 2003 and had been declining for 3-years. Finally, we note that FX may provide a modest tailwind to European EPS again in 2017. Our FX team’s $/€ forecasts trough at $1.02 in mid-2017, implying a rate of depreciation for the euro that peaks at 10%. Chart 31: Stronger dollar would be a tailwind for EPS YoY change in $/€ actual and implied by BofAML FX forecasts 30 20 10 0 -10 -20 $/€ 3m avg YoY -30 3m YoY (at BAML forecast) 01/01 01/03 01/05 01/07 01/09 01/11 01/13 01/15 01/17 Source: BofA Merrill Lynch Global Research, Datastream Chart 32: Change in consensus EPS (%) vs annual market returns: downgrades are the norm and average -10% 30 20 10 0 -10 -20 -30 -40 -50 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 EPS change Dec pre to March post Source: BofA Merrill Lynch Global Research, Datastream, IBES Cal year return Consensus downgrades in our base case – but less than average Our base case 7% EPS growth assumption is below the current bottom up consensus of +14%. Hence, for now we don’t see the prospect of a sustained upgrade cycle. Consensus downgrades are the norm however. 2010 was the last year that consensus forecasts started the year too low. In fact, consensus was too high in 12 of the last 17 years. Moreover, our estimate of 7% EPS growth in 2017 implies less downgrades than usual (10% is the average). It’s also worth noting that over the past 17 years annual consensus downgrades of less than 10% have never been accompanied by negative equity returns for the same calendar year. Sector EPS growth prospects Correlation analysis of sector earnings growth against global GDP suggests that Banks are the sector that may be most sensitive to improvements in global economy. Interest rate developments are likely the key to earnings but they in turn should reflect the nominal growth environment. Real economic growth would also have some effect on credit volumes and collateral valuations though, reinforcing the link from the economy to Bank earnings. Cyclicals unsurprisingly dominate the other sectors with EPS growth geared to global growth. Basic Resources, Chemicals, Tech and Industrials all exhibit a correlation above 70%. Some other cyclicals including Autos and Construction have been had much less correlated EPS growth to global GDP in recent years. In part that reflects that significant earnings volatility in the period analysed. What’s notable for both groups is that expectations already look high for both sectors. Consensus estimates also factor in a rebound in Resources sector EPS growth – but both these sectors have seen the largest earnings declines over the past five years. Forecasts look more restrained in Industrials, Chemicals, Tech – implying mid to high single digit growth in the coming three years. Among Defensives expectations look highest in Telecoms – suggesting 10% average EPS growth in 2016-18 despite the weak trend rate for sector earnings in recent years. Consensus forecasts imply a more modest improvement for Utilities – with just 1% EPS CAGR for 2016-18. Staples and Healthcare are forecast to have high single digit EPS growth in the coming 3 years, implying 2-3pp improvements in the annual growth rate relative the trailing 5-year average for Staples and +6pp for Healthcare. European Equity Strategy | 01 December 2016 13 Chart 33: Correlation of sector EPS to global GDP since 2010 BANKS BASIC RESOURCE REALSTATE CHEMICALS RETAIL TECHNOLOGY INDS GDS & SVS HEALTH CARE PERS & H/H GDS TELECOM FOOD & BEV OIL & GAS TRAVEL & LEIS INSURANCE MEDIA AUTO & PARTS FINANCIAL SVS CON & MAT UTILITIES -20% 0% 20% 40% 60% 80% 100% Source: BofA Merrill Lynch Global Research, Datastream, IBES Chart 34: Trailing vs forward EPS CAGR – ranked by difference Basic Resources Oil & Gas Telecom Construction & Materials Retail Auto & Parts Stoxx 600 Banks Media Utilities Industrial Goods & Sevices HealthCare Chemicals Real estate Food & Bev Technology Personal & Household goods Insurance Financial Services Travel & Leisure 5yr Trailing CAGR 3yr Fwd CAGR Source: BofA Merrill Lynch Global Research, Datastream, IBES -30 -20 -10 0 10 20 Earnings revisions trends. Basic Resources show strongest revisions trends and revisions are still improving relative to trend, in light of the strong upside recently for many metals prices. Autos revisions are next strongest and also show some positive momentum. More broadly most sectors are not showing an improvement in the trend on earnings revisions. Revisions are weakest in Tech having deteriorated more than other sectors over the past six weeks. The improvement in Financials revisions continues and Banks and Financial Services are now in positive territory. Chart 35: 3-month average EPS revisions ratios (ERR) by sector 12% 10% Trend (3m avg) EPS revisions 8% 6% 4% 2% 0% -2% -4% -6% Tech HealthCare Food & Bev Telcos Travel & Leis Insurance Chemicals Media Industrials Stoxx 600 Oils Banks Construction Real Estate Prs & HH Gds FinServ Retail Utility Autos Basics Source: BofA Merrill Lynch Global Research, Datastream, IBES Chart 36: Revisions improving in most sectors (ERR 6wk avg vs 3m avg) 4% Momentum: last 6 weeks vs 3-month 3% average EPS revision ratio (%) 2% 1% 0% -1% -2% -3% -4% Tech Media HealthCare Industrials Construction Stoxx 600 Insurance Oils Real Estate Travel & Leis Retail Utility Food & Bev Chemicals Banks FinServ Telcos Prs & HH Gds Autos Basics Source: BofA Merrill Lynch Global Research, Datastream, IBES 14 European Equity Strategy | 01 December 2016 Eurozone political calendar 2017 4 December: Italian constitutional referendum Our base case is a close “No” vote where Renzi stays and no snap election, given current polls and the outstanding electoral reform court case. BTPs and the banks recaps remain a tail risks for the Italian economy, although the ECB extending QE should help. A big “No” vote would boost Five Star and undermine Renzi into 2018 elections, in our view. 4 December: Austrian presidential election Polls by public broadcaster ORF show the result as very close. Norbert Hofer is standing on an anti-immigrant platform against the moderate former Green leader Alexander Van der Bellen in a rerun of the May vote. The election of Freedom party candidate Norbert Hofer would make Austria the first nation to elect a head of state running on a far right platform since the EU began. 22/ 29 Jan: French Socialist Party presidential nominee elections If President François Hollande decides to run for re-election as the Socialist Party candidate (decision expected Dec 10th) he could be challenged by former Prime Minister Manuel Valls and Economy Minister Arnaud Montebourg. Current second round polls for any combination of these candidates suggest likely Socialist nominee too close to call. 15 March 2017: Dutch elections Prime Minister Mark Rutte currently leads a “purple” coalition with the Dutch Labour party as main second party. But the latest polls suggest both parties could win fewer seats than they have now in 2017. That could make it more challenging to build a government given the need to secure at least 76/150 seats. In terms of who could lead that coalition, polls have Rutte’s People’s Party neck and neck with the antiimmigrant Freedom party led by populist Geert Wilders. Wilders has called for the Netherlands to leave the EU indicated he would call a referendum if elected. A Wilder-Rutte coalition also hasn’t been ruled out according to press reports. 23 April: French first round presidential elections The first round of voting for the next French president will be on 23 April. First round polling suggests the leader of the anti-EU Front National Marine Le Pen is expected to progress to the decisive runoff. At present Republican Candidate Francois Fillon is also expected to make it through. 7 May 2017: French second round presidential elections Current polls, albeit their validity has been called into question by events in 2016, show Fillon securing 65-70% of the vote vs Le Pen in a runoff (see chart below). We note that when her father, Jean-Marie Le Pen, faced Jacques Chirac in the 2002 Presidential elections the FN candidate only received 18% of the vote. Nevertheless, we see a potential Le Pen win as the biggest political risk event for European (and possibly global) equity markets in 2017. By 22 October 2017: German Federal elections Current Chancellor Angela Merkel has announced that she intends to stand for reelection. Current polls have Merkel’s CDU ahead followed by SDP with the eurosceptic Alternative für Deutschland, Greens and Die Linke competing for third spot. While it may be necessary for Merkel to maintain the grand coalition with the SDP, our central case is that we see a continuation of the current German administration and that German elections carry less risk than the earlier French presidential elections. European Equity Strategy | 01 December 2016 15 Politics – populism in the Eurozone? Few predicted that the UK would vote to leave the EU and Donald Trump would win the US presidential election in 2016, least of all pollsters (and many in markets). As Michael Hartnett argues, the rise of populism can be linked to what he refers to as Peak Inequality and Peak Globalisation. Trump and the Brexit campaign tapped into deep apathy with the socio-economic order that for them remains unreformed post-GFC. That’s why the poster boy for this dislocation is often the blue collar voter whose standards of living have not been rising in the increasingly globalised world. The crucial question for investors as we enter a busy year for European politics (see table opposite) is whether the populism train will gather pace or terminate at the Eurozone. Italy risks elevated, but risks two way and banks the bigger issue Although Italy goes to the polls this year, it is worthwhile starting with this Sunday’s vote. In Strategy Insights: Italy risks elevated we argue that our base case is a narrow rejection of the proposed constitutional reform, which is another vote against governing party on Dec 4. But unlike UK/ US, this would be expected and Renzi is likely to stay on so the outcome should not carry the same surprise or uncertainty factor for markets. The tail risk are also two way. A large “No” vote could perceived as supportive of the 5 star movement but a “Yes” vote would be bullish Italy and risk assets more generally. The bigger issue is likely recapitalisation of the Italian banks. This remains a significant tail risk for banks and was part of why we downgraded the sector. A Le Pen victory could prove the biggest risk to European markets in 2017 Probably the most natural fit for the populism theme in 2017 is the French presidential election. Although polls have been somewhat discredited by events this year they remain useful as an indication of where the public mood lies. With that caveat in mind, current voting intentions suggests Front National leader Marine Le Pen will receive enough votes to progress to the second round and is likely to be joined by Republican candidate Francois Fillon. Although when Fillon and Le Pen are polled together in a second round runoff Fillon is ahead by ~65%-35%, Le Pen is seen as capable of appealing to the same anti-establishment / blue collar voters as Trump/ Brexit. Chart 37: Vol already picking up around the French primaries next year 26 25.5 25 24.5 24 23.5 23 22.5 22 VSTOXX 11/29/2016 VSTOXX -1m 21.5 21 Source: Bloomberg Chart 38: Yet Fillon still well ahead of Le Pen in polls of a potential runoff 100 90 80 70 60 50 40 30 20 10 0 12-14 April 15-17 April 13-16 May 10-12 June 14-17 June 9-11 Sept Francois Fillon (%) Marine Le Pen (%) 25-Nov 27-Nov Source: Ifop (12-14 Apr, 14-17 Jun), BVA (15-17 Apr, 13-16 Mar, 10-12 Jun, 9-11 Sept), Odoxa (25 Nov), Harris Interactive (27 Nov). Note: all 2016. Investors’ biggest concerns are that we could see the same narrowing of polls in favour of Le Pen into the election months as we saw in the UK/US. We think this could mean French political risk becomes a major overhang for European equities in H1 2017. The worry is that a Le Pen Presidency could bring the future of the EU and the Euro into question as she has talked about France withdrawing from both and is especially an issue because of the winner takes it all nature of French presidential elections. As James 16 European Equity Strategy | 01 December 2016 Barty argued in The Trump Inflection, Le Pen’s victory has the potential to be even more of an earthquake for the world’s financial markets. Indeed, we have already seen a 1vol move in April 2017 V2X futures since last month. So our central case is French political risk caps markets to the upside for Q1 and most of Q2 but that the centre right candidate Fillon is elected President. As Gilles Moec argues, his pro-market reformist agenda could unlock French growth and we think it could prove a significant positive catalyst for European equities more broadly if the political risk premium is priced out against a solid European and global growth backdrop. More of the same expected in Germany We think Germany carries less political risk than the French election now that Merkel has formally announced she will run again to be Chancellor. As a result, our central case is that Merkel will continue to head a coalition government. We could see the populist AfD win more votes than in 2012, but polls show a clear and decisive margin in favour of the CDU and the existing coalition with the SDP suggests that an extension of their partnership is the most likely eventuality. Chart 39: German polls show a consistent lead for Merkel’s CDU party 40 35 30 25 20 15 10 5 0 CDU SPD AfD September 2, 2016 September 5, 2016 September 7, 2016 September 9, 2016 September 12, 2016 September 14, 2016 September 14, 2016 September 15, 2016 September 16, 2016 September 19, 2016 September 21, 2016 September 21, 2016 September 22, 2016 September 23, 2016 September 26, 2016 September 28, 2016 September 30, 2016 October 3, 2016 October 5, 2016 October 5, 2016 October 7, 2016 October 10, 2016 October 10, 2016 October 12, 2016 October 12, 2016 October 13, 2016 October 13, 2016 October 14, 2016 October 17, 2016 October 19, 2016 October 19, 2016 October 21, 2016 October 24, 2016 October 26, 2016 October 27, 2016 October 28, 2016 November 12, 2016 November 2, 2016 November 2, 2016 November 2, 2016 November 4, 2016 November 7, 2016 November 9, 2016 November 10, 2016 November 14, 2016 November 19, 2016 November 22, 2016 Source: Allensbach (15-Sept, 13-Oct), Emnid (7-Sept, 14-Sept, 21-Sept, 28-Sept, 5-Oct, 12-Oct, 19-Oct, 26-Oct, 2-Nov, 9-Nov, 19-Nov), Forsa (2-Sept, 9-Sept, 16-Sept, 23-Sept, 30-Sept, 7-Oct, 14-Oct, 21-Oct, 28-Oct, 4-Nov), Forschungsgruppe Wahlen (22-Sept, 13-Oct, 27-Oct, 10- Nov), GMS (14-Sept, 12-Oct, 12-Nov), Infratest dimap (21-Sept, 5-Oct, 19-Oct, 2-Nov), INSA (5-Sept, 12-Sept, 19-Sept, 26-Sept, 3-Oct, 10- Oct, 17-Oct, 24-Oct, 2-Nov, 7-Nov, 14-Nov, 22-Nov), Ipsos (10-Oct) Brexit was the big political topic for Europe going into 2016. Going forward we see it as an ongoing issue but mostly for the UK (see UK – Waiting for Brexit for more details). Rising bond yields & equities With the market focus on the sharp bond market sell-off it is worth re-visiting the links between equities and bonds as many investors question whether the effect on equities will become negative the more yields rise. An environment of rising bond yields is not inherently problematic. Over time correlations between bond yields and equities have varied and on average have been very weak (if slightly positive) over the last twenty years. Typically when rising yields reflect improving growth conditions and or rising risk appetite equities have naturally benefitted. Certainly since 2010 for the most part higher yields were accompanied by higher equity prices. Track record mixed for stocks following bond yield spike. Does an exceptionally sharp back up in bond yields represent a downside risk for equities? The historical evidence is inconclusive. We looked at equity market returns in the months following 2.5SD moves in German bond yields (based on a comparison of rolling 3-month yield changes to the 52-week average). The recent spike in German yields peaked at +2.9SD on the same basis. We found 11 comparable episodes since 1980. Equity market returns subsequent to the peak rate of change in bunds were moderately positive – a median European Equity Strategy | 01 December 2016 17 +1.0% after 3 months and +3.7% after 6 months. Subsequent returns were positive in six of the eleven episodes and negative in the other five. Those stats are a little worse than the comparable numbers for the full sample but don’t indicate that a bond yield spike is definitively negative for equities. Chart 40: Rolling 3-month change in bond yields and equities 100 20 15 50 10 0 5 0 -50 -5 -10 -100 -15 -150 -20 01/10 01/12 01/14 01/16 German 10Y 3m chg (LHS, bp) MSCI Europe 3m chg % Table 3: Track record mixed for stocks following bond yield spike Subsequent equity market returns following spike in bond yields (3m change >2.5SD) 3m change in bund yields hits peaks >2.5SD Next 3m % Next 6m % Prior 3m % 10/06/1983 08/03/1985 4.4 5.3 9.2 10.2 7.9 11.1 02/03/1990 5.9 -6.9 -0.4 25/03/1994 15/03/1996 -7.5 4.7 -4.7 7.0 -3.4 4.9 09/07/1999 -3.6 9.8 3.7 22/08/2003 15/06/2007 1.0 -7.1 10.4 -6.1 12.1 11.1 13/06/2008 -8.1 -32.1 1.6 26/11/2010 08/05/2015 6.0 -1.2 3.7 -5.6 7.2 5.9 Median return 1.0 3.7 5.9 % positive 55% 55% 82% Source: BofA Merrill Lynch Global Research, Bloomberg Source: BofA Merrill Lynch Global Research, Bloomberg It matters why yields are rising – higher inflation breakevens key for stocks. Digging a little deeper shows that the underlying dynamics in the bond market matter. Essentially rising inflation breakevens is the key driver for equities. Even when real yields are rising it is the change in implied inflation that has correlated most strongly with equity returns in recent years. Looking at 4-week rolling returns since 2009, in the periods that real yields rose Stoxx 600 returns were a median +1.7% if breakevens were also higher at the same time. In contrast a combination of higher real yields and lower inflation breakevens led to a median -0.7% return. Chart 41: Inflation breakevens on the rise in recent bond market move 2.5 2.0 Chart 42: Rising inflation breakevens the key for equities 2.0 Stoxx 600 4-week returns vs 4-week change in real yields / inflation breakevens (since 2009) 1.5 1.0 0.5 0.0 -0.5 -1.0 German inflation linked 10y -1.5 German 10y breakeven 01/10 01/11 01/12 01/13 01/14 01/15 01/16 Source: BofA Merrill Lynch Global Research, Bloomberg 1.5 1.0 0.5 0.0 -0.5 -1.0 Bund real >+0, b/even +ve Source: BofA Merrill Lynch Global Research, Bloomberg Bund real >+0, b/even -ve 18 European Equity Strategy | 01 December 2016 What then is the prospect for inflation expectations from here? Breakevens have moved significantly already in the context of the Euro area inflation outlook. 5-year, 5-year forward inflation swaps have recovered all the ground they lost earlier in 2016 in Europe and are back to end 2014 levels in the US. At 1.6% in Europe and 2.44% in US there is arguably more limited upside. A return to the range for inflation expectations that prevailed in 2013/14 before the oil price collapse would imply another 30-50bp from here. However, at least in the case of Europe our economists see the outlook for inflation remaining very subdued. Overall we would conclude that equities can see upside from here if bond yields rise towards our fixed income team’s targets as long as inflation expectations are stable to rising at the same time. Rising bond yields pushing Italian spreads wider a risk for equities. Although rising core rates are not necessarily problematic for stocks, an important caveat is the fall out in other parts of the bond markets – particularly in the periphery. The equity market in Europe is sensitive to rising Italian bond spreads – exhibiting a negative correlation in recent years. This is an important risk at the current juncture given the upcoming referendum in Italy and ECB decision on QE extension. Should Italian bond spreads widen significantly from here it would likely weigh on equity valuations, keeping the risk premium high in Europe and in turn offset or outweigh the benefit from rising nominal growth expectations globally. This is perhaps the biggest potential problem for equities in the scenario that bond yields rise further from here. The ECB decision on QE extension is an important risk event in that context. As our economists have discussed in a recent note the risks of an ECB delay in the short term are increasing but their base case remains a QE extension with some tweaks of the capital key – a relatively benign outcome for peripheral sovereigns. Chart 43: Inflation breakevens – room to normalize further? 3.5 3.0 2.5 2.0 1.5 US 5y5y inflation swap Euro 5y5y inflation swap 1.0 01/09 01/10 01/11 01/12 01/13 01/14 01/15 01/16 Source: BofA Merrill Lynch Global Research, Bloomberg Chart 44: Wider Italian bond spreads correlate negatively with equities 6.0 5.0 4.0 3.0 2.0 1.0 Italy-Germnay 10 year bond spread (%) 0.0 01/10 07/11 01/13 07/14 01/16 Source: BofA Merrill Lynch Global Research, Bloomberg European Equity Strategy | 01 December 2016 19 Sector Strategy Markets due a period of consolidation in the short term. The reflation trade has run hard and we’ve taken some chips off the table in recent weeks by cutting our overweight positions in Banks and Basic Resources to neutral and reducing the size of our underweights in some Defensive sectors. In the short term we look for markets to consolidate. Near term risk reward is also a little poorer in light of event risks around the Italian referendum, OPEC’s decision on a potential cut in oil production quotas and the ECB’s decision on QE extension. Look for another leg to the reflation trade in the coming months. We would look for another leg to the cyclical and reflation rotation in the next 1-2 quarters as evidence of stronger global growth and rising inflation materializes. We will look to re-enter sector positions that benefit from global rotation when short term risk reward improves. However, we would look for the pace of the rotation to moderate and become less binary from here. The upside from here for bond yields is more limited. With that in mind we are likely to be more selective in reflation vs bond proxy positions. Politics likely remains an overhang through 1H 2017. Another reason to run a less binary portfolio over the coming months is the potential for political uncertainty to weigh on European markets. Attention near-term will focus on Italy but the French Presidential elections loom in April / May and the tail risk of a Marine Le Pen victory will act as an overhang for Europe in the coming months. It suggests 22017 may well be a year similar to 2016, in which the major indices in Europe have traded in ranges for large parts of the year. Value in some Defensive bond proxies. Valuation looks quite compelling already in some of the bond proxy sectors. Utilities and Healthcare are both trading at the low end of relative valuation ranges and have decent fundamentals in the view of our analyst team. However, rising government bond yields remains the major potential headwind in coming months. We are overweight both sectors. Financials – neutral following the strong recent rally. Banks have re-rated aggressively, taking PE-relative back to average levels. However, the sector continues to have uncertain prospects for EPS recovery given continued ultra-low policy rates in Europe and ongoing tail risks from periphery are an overhang on the sector. Continued long only positioning remains a potential support for the sector should rates and yield curves renew their widening moves. A Risk reward may be better in Insurance – the sector still offers the second highest DY in the market (and relative DY is still at 90 th percentile of the range since 2004). Global quality Cyclicals – waiting for an entry point. Many cyclicals have performed less strongly in the recent rally than Resources and re-rated less aggressively than Financials. With relative PE valuations in-line with or below 17-year averages for the likes of Industrials, Chemicals and Technology we will look for opportunities to build positions in cyclical areas in the coming months. Overowned positioning has been something of a negative for several of these areas (notably Tech) and any signs of a correction could be a catalyst to re-enter an overweight in the sector. Media – raise to overweight. With the outlook for markets set to become less binary we will look to add exposure to quality cyclical areas. One such sector that has lagged this year is Media, making this an interesting entry point. The sector is something of hybrid combining defensive and cyclical components and high and low quality. Media in particular has come back a long way following a six-month period of sustained underperformance. Overweight Oil position dependent on OPEC. As we go to press, the OPEC decision on a deal to cut oil supplies is pending. Our commodity strategists’ base case has been for some kind of deal, with upside into the mid $50s for a deal to cut 1 million barrels per day. However, in the case OPEC fails to agree any deal they see WTI dipping back 20 European Equity Strategy | 01 December 2016 below $40. In other words, the outcome is highly binary in the short term for crude and related equities. We flag to investors that we would consider reducing our weighting in the event of no deal. Assuming OPEC does cut production and oil prices recover up to the high $50s per barrel, as per our commodity strategists views, earnings and cash flows can recover significantly in the coming 12-18 months. Our Oil analysts model between 8 and 17% upside to operating cash flows in 2017 for European integrated stocks if assumed crude prices are increased $10 from $50 to $60. That makes the highest DY in market at ~6% more sustainable out of FCF coverage. Cautious UK domestic (underweight Retail, Travel & Leisure). We are cautious on domestic UK exposure and underweight Retail and Travel & Leisure. To our mind, these companies face a lose-lose trade-off of maintaining margins by passing on higher costs at the expense of volumes, or face margin pressure by absorbing these costs in order to sustain current volumes. Building inflationary pressures point to a post-Christmas consumer squeeze. This could be further compounded OPEC cuts and oil prices rise. The Retail sector is also facing structural margin pressures and unattractive valuations. In Travel & Leisure (two thirds UK listed), profitability is declining from peak levels. Note our analysts also see structural pressures on airlines from overcapacity and competition. See below for more details. Table 4: European Sector Allocation Sector Ticker Index Weight % Stance Delta (bp) Portfolio Weight % Portfolio / Benchmark % Sector Ticker Index Weight % Stance Delta (bp) Portfolio Weight % Portfolio / Benchmark % Oil&Gas SXEP 4.6 o/w +150 6.1 132% Autos&Parts SXAP 3.2 n 0 3.2 100% HealthCare SXDP 12.5 o/w +150 14.0 112% Banks SX7P 12.4 n 0 12.4 100% Media SXMP 2.6 o/w +100 3.6 138% BasicResou SXPP 3.0 n 0 3.0 100% Utilities SX6P 3.9 o/w +100 4.9 125% Chemicals SX4P 5.0 n 0 5.0 100% Constr&Mtr SXOP 3.0 n 0 3.0 100% Trav&Leisr SXTP 1.8 u/w -150 0.3 15% FinServ SXFP 1.9 n 0 1.9 100% Food&Bevrg SX3P 5.9 u/w -150 4.4 75% InduGd&Ser SXNP 11.9 n 0 11.9 100% Retail SXRP 3.1 u/w -200 1.1 36% Insurance SXIP 6.4 n 0 6.4 100% 100.0 +0 100.0 0% Per&HouGds SXQP 8.8 n 0 8.8 100% Real Estate SX86P 1.9 n 0 1.9 100% Technology SX8P 3.8 n 0 3.8 100% Telecomm SXKP 4.1 n 0 4.1 100% Source: BofA Merrill Lynch Global Research, Bloomberg Reflation rotation – tactically got very stretched Over the last two weeks we cut our weightings in Basic Resources and Banks to neutral. That was in response to the signals from our technical models all flashing warning signs that the rotation out of bond proxies into reflation beneficiaries had got very stretched tactically. Our Composite Technical Indicators (CTIs) for sector relative performance hit +100 at the recent high in the case of Basic Resources and +94 for Banks and Insurance. These models combine a range of technical indicators including RSIs, MACDs, Bollinger bands and others and +100 represents maximum overbought. Basic Resources relative price has also reached +2.7SD above the 52-week average, the highest reading for the sector since 2010. Financials hit +1SD while other cyclicals have also peaked at +1.5-2SD in recent weeks. By contrast bonds and equity bond proxies screen as very oversold on these models. All Defensives troughed at -92 or below at some point over the last 4 weeks. On Bollinger scores, relative prices hit between -2.4SD and -3.8SD for the Defensives and also Real Estate. In the case of Utilities (-3.8SD) that is close to a record low. Similarly our CTI readings for macro variables like 10-year Treasury yields, gold and $/yen also hit oversold levels. The models are useful in isolation for highlighting any anomalies in European Equity Strategy | 01 December 2016 21 recent price action for individual assets. However, the fact that we have had multiple signals across a range of sectors and macro prices is typically a warning that markets have moved too far too fast in a more general sense. The last comparable episode was in early July in the wake of the Brexit sell-off. At that point Defensives were hitting record over bought signals with Financials and Cyclicals seeing the opposite. Against the backdrop of heightened uncertainty over the effects of Brexit the models provided a great signal to fade the violent rotation. With these signals in mind we look for a period of consolidation in the rotation trade. The models are short term in nature and are not intended to identify strategic turning points – although like in the case of Brexit they do tend to emphasize when a crescendo is reached. While we would look for another potential leg in some of the reflation trades over the coming months we would prefer to wait for a pull back. The Basic Resources sector provides a useful example in how to use the models tactically. Three times this year prior to the current instance the sector has hit overbought levels on its relative CTI indicator. Previous pullbacks lasted 4-8 weeks and averaged -11% in relative performance terms. Table 5: Composite Technical Indicators for sector relative returns (+100 max overbought; -100 max oversold) Since Oct 27 Sector Latest MIN MAX Healthcare -5 -98 -1 Personal & Household Goods 0 -94 0 Food & Beverages -31 -93 0 Telecom -25 -92 0 Utilities -8 -92 3 Technology 0 -88 26 Media -1 -87 7 Industrial Goods & Services 0 -73 35 Oil & Gas 1 -45 4 Autos 0 -12 8 Chemicals 0 -8 0 Travel & Leisure 0 -27 37 Financial Services -1 -3 43 Construction & Materials 0 -17 45 Retail 0 -42 90 Insurance 36 0 94 Banks 16 8 94 Basic Resources 9 7 100 Source: BofA Merrill Lynch Global Research, Bloomberg Chart 45: Basic Resources 4 th overbought signal this year – previous pullbacks last 4-8 weeks and averaged -11% relative 100 80 60 40 20 0 -20 -40 -60 CTI relative Basics relative -80 12/15 02/16 04/16 06/16 08/16 10/16 Source: BofA Merrill Lynch Global Research, Bloomberg 1.2 1.1 1.0 0.9 0.8 0.7 0.6 Table 6: Bollinger scores –bond proxies 2.5-3.5SD oversold 52-week Z-Score Recent 1m extreme Latest Utility -3.8 -2.6 Real Estate -3.4 -2.1 Media -2.9 -1.8 Food & Bev -2.6 -2.2 HealthCare -2.5 -1.8 Telcos -2.4 -2.2 Travel & Leis -2.1 -0.7 Retail -1.5 -0.4 Prs & HH Gds -1.2 -0.6 Autos 0.8 0.5 Insurance 0.9 0.8 Technology 1.0 0.6 Banks 1.0 0.6 FinServ 1.0 0.6 Industrials 1.5 1.4 Oils 1.6 0.9 Chemicals 1.9 0.8 Construction 2.0 1.2 Basics 2.7 2.2 Source: BofA Merrill Lynch Global Research, Bloomberg Chart 46: Utilities near a record -4SD oversold vs 52-week average 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 Dec-97 Dec-01 Dec-05 Dec-09 Dec-13 Utility - relative price vs 52wk average (SD) Source: BofA Merrill Lynch Global Research, Bloomberg 22 European Equity Strategy | 01 December 2016 Rotation trade – valuations have moved a long way While technical metrics suggest a pause is due in the reflation rotation, we have also seen a significant amount of ground covered from a valuation perspective in the market moves to date. The scatter chart below compares the PE relative change since 8th July (the post Brexit valuation high / low for many sectors) against where PE relative ranks now compared to history. Essentially sectors in the top right have enjoyed a relative multiple re-rating and current relative PE levels are above the median since 1999. Those in the bottom left have seen relative PE multiples de-rate while their current relative PE is below the median since 1999. We make the following observations: • Financials have had the biggest re-rating. Financials re-rated most since Brexit and are now trading around median relative valuation levels. Given the tight link between relative valuations and bond yields in recent years the PErelatives for Banks and Insurance have also recovered much more than would seem justified by the move in the German 10-year yield. The sectors do screen cheaper versus history on PBV reflecting relatively depressed ROEs especially for Banks. Hence, we think PE multiple expansion from here would need to be driven by improving EPS prospects in the sector – something our analysts are sceptical about. • Global Cyclicals trading near or below average relative PE’s. Many global cyclicals have had fairly modest re-ratings since early July and trade on close to median or below valuations. Sectors such as Industrials, Chemicals, Autos, Tech have relative PE multiples 5-10% higher than post Brexit. Relative PE for Chemicals and Industrials are close to post 1999 averages. Construction PE relative does screen as elevated – at the 92 nd percentile. Autos, Tech and Travel & Leisure all have PE relatives in the bottom quartile of their post 1999 range. Relative PE valuations look very reasonable on this basis for Tech, Chemicals and even industrials. In part this may reflect higher than historical average ROE – relative PBV is less flattering for Industrials for example. • Resources sectors – de-rating as EPS recovers. Oil and Basic Resources PE relative has declined more than in any other sector. Although both sectors have seen strong price performance this year, PE multiples are declining from very elevated levels earlier this year as earnings bounce back from depressed levels. Since the end of June Basics 12m forward EPS is up +65%, while the sector index price has risen +33%. For Basics and Oil, performance from here is likely to remain a function of EPS momentum rather than valuations. • Defensives have all de-rated with Telecoms suffering least. Defensive sectors have all seen relative valuations decline over the past four months. Healthcare and Utilities are the two sectors with multiples at lower end of the historical range – notably Healthcare at the 14 th percentile. Utilities relative PE is also close to the prior low hit in 2013. Telecoms screens as somewhat less depressed form a valuation perspective – notwithstanding the poor sector performance in 2016. PE relative remains well above the median levels since 1999. • Staples approaching 2010/14 lows on PE-relative. Staples have also derated severely – in fact Food & Beverage relative PE fell somewhat more than the other Defensives. However, current levels are still somewhat higher versus the historical range (since 1999) than for Healthcare or Utilities. That being said, the PE-relative rose structurally through the 2000s. Over a shorter time frame since 2010 Food & Beverage is also now trading near the bottom quartile. PE-relative is 6-10% above the lows seen in 2010 and 2014 – but those would still allow for healthy 25-30% valuation premiums to the market . European Equity Strategy | 01 December 2016 23 Overall, we find it hard to argue that sectors haven’t moved a long way already from a valuation perspective, even against the context of potentially important inflection points in bond yields and earnings. From here we suspect investors may need to more selective in how they play the rotation theme and consider other variables such as earnings momentum, yield, technicals and positioning when allocating across sectors. Chart 47: Relative PE – recent re / (de) rating compared to percentile ranking of latest relative multiple PE relative - % change since July 8th 2016 30 Banks 25 20 Insurance 15 10 5 Travel & Leis Autos Technology Chemicals FinServ Industrials Retail Construction 0 -5 Real Estate Media Telcos -10 -15 HealthCare Utility Prs & HH Gds Food & Bev Oils Basics -20 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Source: BofA Merrill Lynch Global Research, Datastream, IBES Relative PE - percentile since 1999 Chart 48: Financials valuations have recovered significantly relative to the move in bond yields – relative PE back around average levels 0.90 3.5 0.85 0.80 0.75 0.70 0.65 Banks / Insurance PE-rel 0.60 German 10y (RHS) 01/10 01/11 01/12 01/13 01/14 01/15 01/16 Source: BofA Merrill Lynch Global Research, Datastream, IBES 3 2.5 2 1.5 1 0.5 0 -0.5 Chart 49: Rapid relative de-rating for Staples – relative PE for Food & Beverage still 6-10% above 2010 / 2014 levels 1.70 -0.5 1.60 1.50 1.40 1.30 1.20 PE-relative FOOD & BEV 1.10 German 10y (RHS, inverted) 01/10 01/11 01/12 01/13 01/14 01/15 01/16 Source: BofA Merrill Lynch Global Research, Datastream, IBES 0 0.5 1 1.5 2 2.5 3 3.5 4 24 European Equity Strategy | 01 December 2016 Chart 50: Utilities relative PE close to the 2013 low 1.20 -0.5 Chart 51: Chemicals / Industrials – re-rated but PE-rel not excessive 1.30 5 1.15 1.10 1.05 1.00 0.95 0.90 0.85 PE-relative UTILITIES 0.80 German 10y (RHS, inverted) 01/10 01/11 01/12 01/13 01/14 01/15 01/16 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 1.25 1.20 1.15 1.10 1.05 1.00 Chemicals / Industrials PE-rel German 10y (RHS) 0.95 01/08 01/10 01/12 01/14 01/16 4 3 2 1 0 -1 Source: BofA Merrill Lynch Global Research, Datastream, IBES Source: BofA Merrill Lynch Global Research, Datastream, IBES UK – Waiting for Brexit It’s useful to think about where the UK is today in terms of the four risk factors we identified in our February 2016 Brexit preview: 1) weaker GBP; 2) weaker UK growth; 3) Higher UK risk premia & gilt yields; 4) increased regulatory, political and market uncertainty. Although we saw a severe risk-off move immediately following the Brexit vote, the only truly significant post-Brexit delta has been a weaker GBP. GBP is down 16% vs USD and 11% on a trade weighted basis. In fact, a simple post-Brexit strategy of going equal weighted long UK-listed sectors with above market international sales exposure vs sectors with below market sales exposure would have delivered ~110% returns in USD. Chart 52: GBP and sales exposure have been the key determinants for post-Brexit UK equity returns Performance since Brexit (%$ in USD) 30% 20% UK MATERIALS $ 10% UK FD/STAPLES 0% UK BANKS $ UK CAP GDS $ UK INSURANCE $ UK U$ RTL $ UK ENERGY $ -10% UK UTILITIES $ UK DIV FIN $ -20% UK REAL ESTATE UK RETAILING $ $ UK MEDIA $ UK T/CM SVS $ UK PH/BIO L SCI $ UK H/H PERS PRD $ -30% UK TRANSPT $ -40% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% % International Sales exposure Source: BofA Merrill Lynch Global Research, Bloomberg, Factset. Performance in USD from 23-June-2016 close to 25-Nov-2016 close. The currency move contrasts with the other risk factors. To date, UK growth which has held up better than many expected; policy uncertainty has fallen following a sharp spike; gilts are only 2bp higher than June 23 rd (although this masks a 85bp rally then 87bp selloff); and the UK cost of equity is now down ytd. What Brexit, you could ask. European Equity Strategy | 01 December 2016 25 As we outline below, we think it is just a matter of timing. The political certainty created by the swift election of Theresa May plus the Bank of England’s interventions have delayed, rather than resolved, the underlying uncertainties caused by the vote. Chart 53: UK PMIs tanked post-Brexit but have recovered 65 60 55 Average since 2010 Composite PMI 50 GDP, % qoq, preliminary estimates (rhs) 45 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Source: BofA Merrill Lynch Global Research, Markit, ONS. 1.4 0.9 0.4 -0.1 -0.6 Chart 54: While retail sales have remained strong 10 8 Oct retail 6 4 2 0 -2 -4 -6 1984 Consumer confidence Real consumption, %yoy Retail sales volumes ex fuel, % yoy 1988 1992 1996 2000 2004 2008 BAML est. of confidence if inflation 2012 @3% 2016 Retail sales volumes. Source: BofA Merrill Lynch Global Research, GfK, ONS. 2017: Falling growth, negotiations and a consumer squeeze We think there are clear warning signs that conditions are deteriorating, uncertainty is set to return and a consumer squeeze is coming for the UK. Falling growth to compound deficit problems Real gdp is only expected to fall 0.1% in 2016 vs the March forecast. But the UK Office of Budgetary Responsibility expects growth to slip by 0.8% next year (2.2% to 1.4%) and 0.4% on 2018 (2.1% to 1.7%) vs March. A notable slice of this is can be attributed to the OBR’s estimate that Brexit added £59bn to UK borrowing to 2022, or nearly £200mn a week. These numbers include Phillip Hammond’s sensible but small measures. Our UK economist is more pessimistic forecasting 0.9% in 2017 and 0.7% in 2018. Even if we split the two, that represents a 50% decline in expected 2017 gdp and 40% decline in 2018. The OBR also expects public sector net debt to hit its highest level since 1964-65 in 2017-18 at a time when the UK already relies on “the kindness of strangers” to finance its growing twin deficit. 26 European Equity Strategy | 01 December 2016 Chart 55: OBR / BofAML UK GDP forecasts materially lower in 2017 2.1 2.0 OBR real gdp %yoy growth forecast BAML real gdp %yoy growth forecast OBR UK real gdp %yoy growth March vs Nov 2016 forecasts 1.4 0.9 1.7 0.7 0.1 2016 2017 2018 -0.4 -0.8 Source: BofA Merrill Lynch Global Research, Office of Budgetary Responsibility Chart 56: UK Public sector net debt is expected to return to 1960s levels 120 100 80 60 40 20 0 UK Public sector net debt as % GDP… 1960-61 1964-65 1968-69 1972-73 1976-77 1980-81 1984-85 1988-89 1992-93 1996-97 2000-01 2004-05 2008-09 2012-13 2016-17 2020-21 Source: Office of Budgetary Responsibility Chart 57: The weaker econ outlook has helped decouple GBP and gilts since late Sept’16 2.5 2 1.5 1 0.5 0 Oct-15 Dec-15 Source: Bloomberg Feb-16 10y gilt yield GBP/USD (RHS) Apr-16 Jun-16 Aug-16 Oct-16 1.6 1.55 1.5 1.45 1.4 1.35 1.3 1.25 1.2 Certainty that Brexit negotiations will start, but uncertainty on the details Against this debt and growth backdrop, investors are likely to want clarity and visibility on policymaking in order to continue funding the UK’s deficit in our view. We think they could be disappointed. Firstly, the Government has committed to triggering Article 50 by the end of March 2017. We think this is likely irrespective of the outcome of the Judicial Review on where the legislative power lies for making that decision. Second, the Government’s formal position is not to announce its negotiating strategy in public. A lack of insight into the UK’s future trading relationship with its biggest export market for goods and services is a difficult backdrop upon which to continue investing in the UK, even if a few companies have taken that decision already. Third, we think there will have to be a resolution to the trade-off between the Government’s desire to control immigration and reach a beneficial economic settlement. The problem, as is often repeated by EU leaders, is that curbing migration puts the UK on a collision course with the EU’s four freedoms and therefore at odds with access to the single market. That’s why our base case remains a so called “hard Brexit”, but even now our colleagues in FX strategy think investors are not positioned for this. Hence their GBP/USD forecast of 1.15 for Q1/Q2 2017. Finally, a major concern for investors and especially business investment would be if the UK faces a “cliff edge” for trade terms in 2019 (on the assumption article 50 is triggered). While a transition deal would be a potential positive development next year, the absence of such a deal before or soon after article 50 is triggered could be another reason for policy uncertainty to spike higher again. European Equity Strategy | 01 December 2016 27 Chart 58: The dip in UK policy risk is likely to be short lived if the Govt keeps to its commitment to trigger A50 in Q1 without providing clarity on its negotiating position 1200 1000 800 UK Economic Policy Uncertainty German Economic Policy Uncertainty 600 400 200 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Bloomberg Building inflationary pressures point to post-Christmas consumer squeeze The third act in waiting for Brexit is cost-push inflation from the fall in GBP. So far, consumer spending has held up far better than most expected, especially retail spending by the over 50s. But there is evidence the inflationary canary is starting to sing. The charts below show that the move in CPI has lagged sharp rises in manufacturing output prices, utility prices and food prices in the past two months. Chart 59: Firms report sharp increases in output prices 66.0 62.0 58.0 54.0 50.0 46.0 42.0 38.0 Manufacturing output prices (PMI, lagged 3 months) Industrial goods inflation (rhs) 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: BofA Merrill Lynch Global Research, Markit, ONS. 6 4 2 0 -2 -4 -6 Chart 60: Chunky utility price increases on the horizon 140 120 100 80 60 40 20 0 -20 -40 -60 Natural gas price, 6 month forward, % 12m/12m Natural gas price, spot, % 12m/12m CPI utilities, % yoy (rhs) 2003 2005 2007 2009 2011 2013 2015 2017 50 45 40 35 30 25 20 15 10 5 0 -5 -10 -15 Source: BofA Merrill Lynch Global Research, ONS, Bloomberg Chart 61: Food prices are key to watch 14 CPI food prices, 12 BAML forecast, % 10 yoy Food input prices, 8 % yoy, lagged 3 months (rhs) 6 4 2 0 -2 -4 -6 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 -10 -20 Food input prices calculated as an average of domestically produced and imported food. BofA Merrill Lynch Global Research, ONS. 40 30 20 10 0 To understand this delay it is worth remembering “Marmitegate” and the pressure put on companies not to raise the prices of household brands. The incident also illustrates the margin pressure building up in the system and challenges posed to producers, vendors and consumers as to who will absorb the higher costs. According to the Chairman of the UK Food and Drink Federation many companies may be waiting until post-Christmas to change prices, which Ian Wright estimates could rise as much as 8%. If that happens at the same time as power prices hit seasonal highs, the consumer could start to feel the pinch. To avoid this leading to a contraction in demand, workers we would need to see strong nominal wage growth. However, the Institute of Fiscal Studies does not expect real wages to return to 2008 levels until 2021. The tightness of the UK labour market could also cushion any blow, but we note jobless claims have started to rise again and businesses may be less likely to hire if uncertainty, for reasons outlined above, picks up again. 28 European Equity Strategy | 01 December 2016 Chart 62: Real wages likely to fall 6 4 2 0 -2 Real wages, BAML forecast -4 Average weekly earnings, % 3m yoy CPI inflation, BAML forecast -6 2002 2004 2006 2008 2010 2012 2014 2016 2018 Real wages calculated as average weekly earnings minus CPI inflationSource: BofA Merrill Lynch Global Research, ONS. Chart 63: REC and PMI point to higher unemployment 150 Claimant count, 3m change, inverted REC placements, lagged 3m (rhs) 100 Composite PMI employment (rhs) 50 0 -50 -100 -150 -200 -250 2004 2006 2008 2010 2012 2014 2016 REC placements is an average of permanent and temporary placements. REC and PMI shown as standard deviations from average. Source: BofA Merrill Lynch Global Research, Markit. 2 1 0 -1 -2 -3 -4 Given all of the above, we reiterate our preference for avoiding sectors with a high proportion of domestic UK companies. To our mind, these companies face a lose-lose trade-off of maintaining margins by passing on higher costs at the expense of volumes, or face margin pressure by absorbing these costs in order to sustain current volumes in our view. This could be further compounded if our Oil Strategists’ forecasts are right and Brent averages ~$60/bb following an OPEC cut. But how much is in the price? The pushback to our view is that the forecasted deterioration in growth hasn’t really materialised and investors are already pricing it in a lot of bad news. For instance, Easyjet is down nearly 35% and investors are still underweight the UK in the FMS. While this is the case for certain stocks, at a sector level investors appear to have squared off their underweights in Retail/ Travel according to the FMS. Both sectors also back near pre-Brexit levels relative to the market (albeit Travel reflects the recent oil price weakness). Chart 64: Source: Brexit sectors no longer underowned by investors Construction Ind. Gds&Svs Technology Healthcare Autos Travel&Leis. Banks Telecoms Insurance Retail Chemicals Media Real Estate Food&Bev PHH Goods Oil & Gas Utilities Financial Svs Basic Res. -35 -25 -15 -5 5 15 25 Source: BofA Merrill Lynch Global Research Nov-16 Oct-16 Chart 65: Retail and Travel are some way off their post-Brexit lows 0.93 0.74 0.92 0.72 0.91 0.7 0.9 0.68 0.89 0.66 0.88 0.64 0.87 0.62 0.86 Stoxx Retail relative Stoxx Travel & Leisure relative 0.6 0.85 0.58 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Source: Bloomberg European Equity Strategy | 01 December 2016 29 Sector Trades Table 7: European Sectors – Summary of investment case and risks Sector (Ticker) HealthCare (SXDP Index) Oil & Gas (SXEP Index) Media (SXMP Index) Utilities (SX6P Index) Index Weight % Stance Delta (bp) 12.5 O/W +150 4.6 O/W -150 2.6 O/W +100 3.9 O/W +100 Summary of view Laggard despite Republican clean sweep reducing legislative risks, valuations close to 2010-12 lows at trough of patent cliff but sector team expect 11% EPS CAGR 2018-2021 supporting 17/18x PE (currently on 13x 2018), catalysts from new products set to be announced in 2017. Risks: rising bond yields continues, pipelines fail to realise, strong growth leads to risk-on rally led by value/ rotation out of quality. Forecast Brent to average ~$61/bbl in 2017 on supportive demand backdrop (EM), OPEC reduction, supply destruction causing rebalance Oil team modeling 8%-17% upside from crude rally meaning FCF covers ~6% DY and EPS to improve (revisions 2nd best in market) Risks: OPEC fails to cut supply pushing rebalancing out, strong dollar and protectionism curtail global demand and EM growth. Market laggard and de-rated presenting favourable entry points, optionality to improving EU consumer confidence even if UK consumer set to be squeezed next year, historically outperforms when dollar/ PMIs/ inflation rising, positioning now underweight in FMS. Risks: UK growth/ EU consumer confidence drop quickly, investors prefer cheaper cyclicals if we see another leg to risk-on rally. Big underperformer in reflation rotation given defensive yield characteristics now oversold, consistent underweight in FMS but fundamental outlook positive with cyclical/ earnings improvement from higher power prices/ CSPP/ changing sector composition. Risks: lack of differentiation from investors in rising yields continues, commodity prices roll, regulatory risk increases. Autos & Parts (SXAP Index) Banks (SX7P Index) Basic Resources (SXPP Index) Chemicals (SX4P Index) Const & Mats (SXOP Index) Fin Srvs (SXFP Index) Ind Gd&Svs (SXNP Index) Insurance (SXIP Index) Persnl & HHG (SXQP Index) Real Estate (SX86P Index) Telecomm (SXKP Index) Technology (SX8P Index) Food & Bev (SX3P Index) Travel & Leisr (SXTP Index) Retail (SXRP Index) 3.2 M/W 0 12.4 M/W 0 3 M/W 0 5 M/W 0 3 M/W 0 1.9 M/W 0 11.9 M/W 0 6.4 M/W 0 8.8 M/W 0 1.9 M/W 0 3.8 M/W 0 4.1 M/W 0 5.9 U/W -150 1.8 U/W -150 3.1 U/W -200 Bull case: Margins supported by strong EU/ China sales, lease growth in US, valuations at multi-year lows, positioning neutral, cyclical beta Bear case: Future car raises questions over terminal value, US/UK markets peaked, Truck market has turned, China tax cut to end Bull case: global yields and inflation continue to rise as global growth pushes higher, Italian banks successfully recap and earnings improve. Bear case: LT profitability challenges persists (ECB monetary policy), UK large caps underperform, rates move unwinds. Bull case: Investors still u/w, Trump delivers on fiscal not trade, DXY capped so EM recovery / China cycle continues, higher metals lifts FCF. Bear case: Protectionism rises, China cycle slows, hawkish Fed hurts EM rally, metals prices fail to sustain recovery. Bull case: Cheap on relative PE/ DY, M&A pick-up, cyclically geared to improving EM growth, higher quality characteristics vs other cyclicals. Bear case: OPEC deal fails hurting oil, industrial cycle potentially at risk from protectionism, margins unsustainable given at highest since 2004 Bull case: geared to expected increase in fiscal spending (esp US), EU mfg and construction PMIs solid, US ISM / housing market strong Bear case: Most expensive sector on relative basis, re-rated on fiscal expectations but EPS hasn't followed, exposure to softening UK market Bull case: High proportion of dollar earnings/ sterling reporters, geared to pick up stronger markets, potential M&A targets Bear case: less attractive valuations and not as levered into better growth/ rising bond yields than other financials (e.g. Banks). Bull case: US mfg ISM strong, EU OECD lead indicator improving, expect fiscal spending in US, high RoE and consistent earnings Bear case: valuations stretched on PBV, big outperformance driven by re-rating more than eps growth, Q3 earnings season has been weak. Bull case: beneficiary of rising yields, strong balance sheets, cheap on PBV/ PE and attractive, growing and covered DY. Positioning still light. Bear case: lower beta and longer cycle than Banks, vulnerable to any rally in bond prices from Italy risks, higher DY in more cyclical sectors. Bull case: luxury stocks delivering growth, tobacco structural outperformer, has de-rated following Brexit rally but earnings outlook decent. Bear case: margins at 10y peak, stiff competition from digital innovation, EM consumer demand volatile, vulnerable to rising rates. Bull case: oversold on CTI, at 10y lows on relative PE and bottom quintile on PBV, UK market held up post-Brexit, yield attractive if bonds rally Bear case: positioning o/w vs history, REITs vulnerable to rising yields backdrop, rental yields under pressure fall if UK/ EU growth slumps. Bull case: strong FCFY and improving balance sheets, valuations not expensive, positioning has unwound, beneficiary of CSPP, major laggard. Bear case: structural challenges to monetising data, consolidation not set to play out, vulnerable to further outflows in rising yield environment. Bull case: valuations less stretched, semis cycle proving resilient, higher "quality" cyclical, positioning neutral, structural growth Bear case: vulnerable to rotation into value sectors in a risk-on market, margins close to peak, structural challenges for Nokia/ Ericsson. Highest correlation to rising yields/ bond proxy, valuations still not cheap on a range of metrics (esp vs Healthcare), falling earnings revisions. Risks: Oversold vs history in rotation move, sector has de-rated enough if bond yields capped/ CB don’t hike/ growth disappoints. Airlines in structural decline, negatively correlated to higher oil, vulnerable to weaker UK and returns at peaks levels, valuations not cheap Risks: Oil rally takes longer to materialise if OPEC fails to cut, European/ global growth picks up and UK gdp surprises to upside. Most vulnerable to consumer squeeze in UK, margins in structural decline, supermarkets have had their relief rally, expensive on PE/ PBV/DY Risks: modest inflation provides pricing power, Eurozone growth boosts consumer demand, positioning light, strong x-mas season. Source: BofA Merrill Lynch Global Research 30 European Equity Strategy | 01 December 2016 Underweight Retail In addition to Brexit concerns, we also see a number of fundamental reasons to reiterate out underperform on Retail. • Structural margin pressures: Aside from Brexit, retailers face declining returns as online disruptors and discounters drive up competition. EBITDA margins have fallen from 8% in 2010 to close to 7% in 2016 and RoE has declined by nearly 3% since 2004. We think this structural trend has further to run. • Valuations are also unattractive. Retail remains on a significant premium to the market on absolute terms (17.3x 2017 PE vs 14.2x) and is expensive versus its own history at 20% above its 10y relative average on PE and 92%ile on PBV, while it has the second lowest dividend in the market (2.9%). Even if you strip H&M and Inditex the sector is towards the higher range of its post-GFC range. • UK supermarkets have had their relief rally. Despite challenges facing UK food retailers, Tesco has rallied 25% and Morrison’s 15% since Brexit as retail spending has held up and the short base grew massively immediately following the UK-EU vote. Yet as Xavier Le Mene notes, this has largely been because they have gained market share from Asda and investors have bought into their new management plans. However, Xavier see limited upside potential for either next year and there is a risk that Asda starts to recoup lost ground under its new management too. Chart 66: Stiff competition means retail margins are structural declining 8.3% 7.8% 7.3% Retail EBITDA margin 6.8% Chart 67: Market share gains have largely been at Asda’s expense Tesco Aldi Lidl Waitrose Morrisons Sainsbury's Asda -100 -50 0 50 100 Market share of grocers, yoy Source: BofA Merrill Lynch Global Research, Bloomberg, Datastream, IBES Source: Kantar Worldpanel Chart 68: Retail is expensive on a range of metrics Chart 69: Not cheap even if you strip out the two biggest ex-UK names 1.70 1.60 1.50 Retail 12m fwd PBV relative 16 Stoxx Retail PE Stoxx Retail ex-Inditex PE Stoxx Retail ex-Indi/H&M PE 1.40 1.30 11 1.20 1.10 1.00 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 201 6 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: BofA Merrill Lynch Global Research, Bloomberg, Datastream, IBES Source: BofA Merrill Lynch Global Research, Datastream European Equity Strategy | 01 December 2016 31 Underweight Travel & Leisure • Airlines in structural decline: our European Airlines analyst thinks overcapacity (networks set to grow 7% yoy to 2020) and competition from low cost/ ME carriers is driving prices and passenger yields lower across the board. • Negatively correlated to Oil: the sector is negatively correlated to the Oil price and despite recent weakness, our Commodity Strategist expects OPEC to cut by 500k b/d or 1 million b/d. Should OPEC cut with firm quotas and a tight control mechanism, they see WTI prices averaging $59/bbl. • Watch UK consumer confidence closely: the combined effect of the challenges we identified earlier starting to mount for the UK consumer and the drop in the value of the pound could reduce demand for and expenditure on overseas holidays. This would weigh on the travel operator part of the sector. If the bulk of sterling move is over the boost for dollar earnings like Compass will also likely fade. • Peak returns: unlike Retail, T&L margins (98%ile since 2004) and RoEs (85%ile) are close to all-time highs. We think returns may well have peaked therefore given the backdrop of rising oil, weakening consumer confidence in the UK and structural overcapacity in airlines. This is reflected in the fact that PBV are on 2.8x for the sector, which is top quintile for the sector since 2004. Chart 70: Competition & overcapacity pushing airline yields down Chart 71: Rising oil would weigh on Travel earnings 140 120 100 80 60 40 Brent Oil 20 BofAML WTI forecasts Stoxx Travel & Leisure EPS (RHS - inverted) 0 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14 Nov-15 Nov-16 Nov-17 6 8 10 12 14 16 18 20 Source: Company data Source: BofA Merrill Lynch Global Research, Bloomberg, Datastream, IBES Chart 72: The UK consumer will have lower purchasing power next year Chart 73: Yet sector RoEs remain close to all-time highs 10 0 GfK UK Consumer Confidence Index Travel & Leisure price relative 0.75 0.7 0.65 24.0% 22.0% 20.0% Travel & Leisure RoE -10 -20 -30 -40 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 0.6 0.55 0.5 0.45 0.4 18.0% 16.0% 14.0% 12.0% 10.0% 8.0% 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Bloomberg Source: BofA Merrill Lynch Global Research, Datastream, IBES 32 European Equity Strategy | 01 December 2016 Media – raise to overweight Favourable entry point Media has been is a big laggard following a six-month period of sustained underperformance and hit very oversold levels on our CTIs in mid-November. Although Media is a bit more domestic than Tech both are “quality” cyclicals and typically trade fairly in line with one another. However, the relative is now back at 2009 lows. Optionality on European consumer We are bearish on the outlook for the UK consumer but consumer confidence has been steadily rising in the Eurozone since 2012 and the sector has tracked this measure very closely. We note however that the two have disconnected recently. We think Media is more likely to catch up then confidence fall given economists’ fairly positive view on Eurozone growth next year, and the potential for upside surprises to US growth. Chart 74: Favourable entry point for Media Media and Tech are both “quality” cyclicals but the relative is at a 7y low 1 0.95 0.9 0.85 0.8 0.75 0.7 0.65 Source: Bloomberg Stoxx Media relative to Tech Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Chart 75: The pick-up in EU Consumer Confidence should boost Media 0.9 0.85 0.8 0.75 0.7 0.65 0.6 0.55 Source: Bloomberg Stoxx Media Price relative European Commission Consumer Confidence Index 0 -5 -10 -15 -20 -25 -30 Media historically outperforms when PMIs and inflation rising The average return for Media when PMIs and inflation are both rising is 0.6% relative but the sector has underperformed by 2% month to date. A stronger dollar is also a positive historically for Media given that many large caps within the sector, notably agencies, are large dollar earners. But again, the two have disconnected recently. Valuations now at a small discount to the market Media has de-rated by nearly four PE points (from 19.7 to 16) since the April 2015 highs and the sector now trades on a 5% discount to its average vs the market. We think the improving global growth backdrop will support earnings and should mean the sector can re-rate. European Equity Strategy | 01 December 2016 33 Chart 76: A stronger dollar benefits agencies with global exposure 0.9 0.85 0.8 0.75 0.7 0.65 0.6 0.55 Stoxx Media price relative 0.5 DXY Curncy (RHS) 0.45 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Bloomberg 105 100 95 90 85 80 75 70 65 60 Chart 77: Media now at a small discount to its 10y average vs market 1.30 1.25 1.20 1.15 1.10 1.05 1.00 0.95 0.90 Media 12m fwd PE relative 0.85 0.80 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: BofA Merrill Lynch Global Research, Bloomberg, Datastream, IBES Overweight Healthcare Healthcare looks very attractively valued and we see compelling risk reward in the sector on an outright basis at current levels. The fundamental bull case for Health rests on the strong pipeline of new products for the big cap pharma universe. Our sector analysts forecast EU Pharma to deliver a 2018-21E EPS CAGR of 11%, up from mid-single digit levels in recent years. Historically that would justify a PE re-rating and a multiple for the pharma sub-sector nearer 17-18x than the current 13x 2018 PE. We believe the Republican clean sweep in the US elections represents a positive catalyst as it significantly decreases the potential for legislative initiatives to aggressively control drug pricing in the US. The catalyst for the sector to re-rate will come progressively from newsflow around new products. The next 12 months should see progress on this front with several of the European large caps expected to announce key data on important drugs in 2017. Chart 78: Pharma’s improving growth outlook not reflected in PE 3 Year Sales, EBIT and EPS CAGR Majors and 12 month forward PE ratio 15% 10% 5% 0% -5% -10% 05-08A 06-09A 07-10A 08-11A 09-12A 10-13A 11-14A 12-15A 13-16E 14-17E 15-18E 16-19E 17-20E 18-21E 3yr Sales CAGR 3yr EPS CAGR Source: BofA Merrill Lynch Global Research 3yr EBIT CAGR 12 month forward PE (rhs) 20 18 16 14 12 10 8 6 Chart 79: Healthcare PE relative back near market multiple and lowest since 2011 when patent cliff was at its worst 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 HealthCare 12m fwd PE relative 0.80 1999 2001 2003 2005 2007 2009 2011 2013 2015 Source: BofA Merrill Lynch Global Research, Datastream, IBES, Bloomberg Healthcare’s forward PE is now down to just a 7% premium relative to the market and nearing the valuation lows recorded in 2010-12 when the patent cliff was at its worst and pipelines were very weak. Today pipelines are twice the size they were in 2011 and innovation is the key to growth in the sector - pricing power remains strong in drug categories with differentiated products. The new product launches expected between 2015 and 2018 add up to potential sales of $133 billion. 34 European Equity Strategy | 01 December 2016 Chart 80: Stocks mostly trade above ex-pipeline value Pipelines are free for most stocks 25% 15% 5% -5% -15% -25% -35% 17% 1% -2% -14% -16% -16% -22% -25% -10% Chart 81: Growth from new products - $138bn launching 16-20E Peak unrisk-adjusted sales potential (USDm) of product launchs by year 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 Premium/(Discount) to ex pipeline DCF 2008 2009 2010 2011 2012 2013 2014 2015 2016E 2017E 2018E 2019E 2020E Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Overweight Utilities The Utilities sector has suffered badly from the back up in bond yields. However, fundamentals for the sector are actually improving relative to recent history. The sector is the biggest direct beneficiary of corporate QE in the UK and Euro are (more than half of the sector are eligible for the ECB’s Corporate Sector Purchase Program) meaning it can gain more than most other sectors from potential refinancing savings. This cushions any effect on debt costs from higher bond yields as corporate bond yields are still very low. Earnings and cash flow are improving. The bottoming out of the commodity cycle has supported a turn to the upside for power prices. This has helped earning to trough and analyst revisions have been positive throughout the last few months of underperformance. Balance sheets and dividends in most cases now also look sustainable. Valuation multiples for the Utilities sector are attractive relative to history and compared to other Defensives. EV/EBITDA for the sector sits at 7.3x on Bloomberg estimates. That is a 20% discount to the market and is near 10-year lows on a relative basis. With dividends more secure the relative DY becomes more attractive at 2-year highs. Chart 82: Utilities EV / EBITDA relative to market near10-year lows 1.10 1.05 Utilities 1.00 0.95 0.90 0.85 0.80 0.75 FY1 EV/EBITDA relative 0.70 07/05 07/07 07/09 07/11 07/13 07/15 Source: BofA Merrill Lynch Global Research, Bloomberg Chart 83: DPS more secure now but the relative yield is at 2yr highs 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 Utility 12m fwd DY relative 0.90 0.80 02/04 02/06 02/08 02/10 02/12 02/14 02/16 Source: BofA Merrill Lynch Global Research, Datastream, IBES European Equity Strategy | 01 December 2016 35 Analyst Certification I, Ronan Carr, CFA, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report. 36 European Equity Strategy | 01 December 2016 Disclosures Important Disclosures FUNDAMENTAL EQUITY OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK RATINGS, indicators of potential price fluctuation, are: A - Low, B - Medium and C - High. INVESTMENT RATINGS reflect the analyst’s assessment of a stock’s: (i) absolute total return potential and (ii) attractiveness for investment relative to other stocks within its Coverage Cluster (defined below). 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