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European Equity Strategy
2017 year ahead – Refining the reflation
rotation
01 December 2016
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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.
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Timestamp: 01 December 2016 12:00AM EST
Equity Strategy
Europe
Ronan Carr, CFA >>
European Equity Strategist
MLI (UK)
+44 20 7996 3292
ronan.carr@baml.com
James Barty >>
Investment Strategist
MLI (UK)
+44 20 7996 3291
james.barty@baml.com
Tommy Ricketts >>
European Equity Strategist
MLI (UK)
+44 20 7996 3294
tommy.ricketts@baml.com
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