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 amanda.ens@baml.com
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
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
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). There are three investment ratings: 1 - Buy stocks are expected to have a total
return of at least 10% and are the most attractive stocks in the coverage cluster; 2 - Neutral stocks are expected to remain flat or increase in value and are less attractive than
Buy rated stocks and 3 - Underperform stocks are the least attractive stocks in a coverage cluster. Analysts assign investment ratings considering, among other things, the 0-12
month total return expectation for a stock and the firm’s guidelines for ratings dispersions (shown in the table below). The current price objective for a stock should be
referenced to better understand the total return expectation at any given time. The price objective reflects the analyst’s view of the potential price appreciation (depreciation).
Investment rating Total return expectation (within 12-month period of date of initial rating) Ratings dispersion guidelines for coverage cluster*
Buy ≥ 10% ≤ 70%
Neutral ≥ 0% ≤ 30%
Underperform N/A ≥ 20%
* Ratings dispersions may vary from time to time where BofA Merrill Lynch Research believes it better reflects the investment prospects of stocks in a Coverage Cluster.
INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend considered to be secure), 8 - same/lower (dividend not considered to be secure) and 9 - pays
no cash dividend. Coverage Cluster is comprised of stocks covered by a single analyst or two or more analysts sharing a common industry, sector, region or other classification(s). A stock’s
coverage cluster is included in the most recent BofA Merrill Lynch report referencing the stock.
BofA Merrill Lynch Research Personnel (including the analyst(s) responsible for this report) receive compensation based upon, among other factors, the overall profitability of Bank of America
Corporation, including profits derived from investment banking. The analyst(s) responsible for this report may also receive compensation based upon, among other factors, the overall
profitability of the Bank’s sales and trading businesses relating to the class of securities or financial instruments for which such analyst is responsible.
Other Important Disclosures
Prices are indicative and for information purposes only. Except as otherwise stated in the report, for the purpose of any recommendation in relation to: (i) an equity security, the price
referenced is the publicly traded price of the security as of close of business on the day prior to the date of the report or, if the report is published during intraday trading, the price referenced is
indicative of the traded price as of the date and time of the report; or (ii) a debt security (including equity preferred and CDS), prices are indicative as of the date and time of the report and are
from various sources including Bank of America Merrill Lynch trading desks.
The date and time of completion of the production of any recommendation in this report shall be the date and time of dissemination of this report as recorded in the report timestamp.
Officers of MLPF&S or one or more of its affiliates (other than research analysts) may have a financial interest in securities of the issuer(s) or in related investments.
BofA Merrill Lynch Global Research policies relating to conflicts of interest are described at http://go.bofa.com/coi.
"BofA Merrill Lynch" includes Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S") and its affiliates. Investors should contact their BofA Merrill Lynch representative or
Merrill Lynch Global Wealth Management financial advisor if they have questions concerning this report. "BofA Merrill Lynch" and "Merrill Lynch" are each global brands for BofA
Merrill Lynch Global Research.
Information relating to Non-US affiliates of BofA Merrill Lynch and Distribution of Affiliate Research Reports:
MLPF&S distributes, or may in the future distribute, research reports of the following non-US affiliates in the US (short name: legal name, regulator): Merrill Lynch (South Africa): Merrill Lynch
South Africa (Pty) Ltd., regulated by The Financial Service Board; MLI (UK): Merrill Lynch International, regulated by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority
(PRA); Merrill Lynch (Australia): Merrill Lynch Equities (Australia) Limited, regulated by the Australian Securities and Investments Commission; Merrill Lynch (Hong Kong): Merrill Lynch (Asia
Pacific) Limited, regulated by the Hong Kong Securities and Futures Commission (HKSFC); Merrill Lynch (Singapore): Merrill Lynch (Singapore) Pte Ltd, regulated by the Monetary Authority of
Singapore (MAS); Merrill Lynch (Canada): Merrill Lynch Canada Inc, regulated by the Investment Industry Regulatory Organization of Canada; Merrill Lynch (Mexico): Merrill Lynch Mexico, SA de
CV, Casa de Bolsa, regulated by the Comisión Nacional Bancaria y de Valores; Merrill Lynch (Argentina): Merrill Lynch Argentina SA, regulated by Comisión Nacional de Valores; Merrill Lynch
(Japan): Merrill Lynch Japan Securities Co., Ltd., regulated by the Financial Services Agency; Merrill Lynch (Seoul): Merrill Lynch International Incorporated (Seoul Branch) regulated by the
Financial Supervisory Service; Merrill Lynch (Taiwan): Merrill Lynch Securities (Taiwan) Ltd., regulated by the Securities and Futures Bureau; DSP Merrill Lynch (India): DSP Merrill Lynch Limited,
regulated by the Securities and Exchange Board of India; PT Merrill Lynch (Indonesia): PT Merrill Lynch Indonesia, regulated by Otoritas Jasa Keuangan (OJK); Merrill Lynch (Israel): Merrill Lynch
Israel Limited, regulated by Israel Securities Authority; Merrill Lynch (Russia): OOO Merrill Lynch Securities, Moscow, regulated by the Central Bank of the Russian Federation; Merrill Lynch
(DIFC): Merrill Lynch International (DIFC Branch), regulated by the Dubai Financial Services Authority (DFSA); Merrill Lynch (Spain): Merrill Lynch Capital Markets Espana, S.A.S.V., regulated by
Comisión Nacional del Mercado De Valores; Merrill Lynch (Brazil): Bank of America Merrill Lynch Banco Multiplo S.A., regulated by Comissão de Valores Mobiliários; Merrill Lynch KSA Company,
Merrill Lynch Kingdom of Saudi Arabia Company, regulated by the Capital Market Authority.
This research report: has been approved for publication and is distributed in the United Kingdom (UK) to professional clients and eligible counterparties (as each is defined in the rules of the
FCA and the PRA) by MLI (UK) and Bank of America Merrill Lynch International Limited, which are authorized by the PRA and regulated by the FCA and the PRA, and is distributed in the UK to
retail clients (as defined in the rules of the FCA and the PRA) by Merrill Lynch International Bank Limited, London Branch, which is authorized by the Central Bank of Ireland and subject to
limited regulation by the FCA and PRA - details about the extent of our regulation by the FCA and PRA are available from us on request; has been considered and distributed in Japan by Merrill
Lynch (Japan), a registered securities dealer under the Financial Instruments and Exchange Act in Japan; is issued and distributed in Hong Kong by Merrill Lynch (Hong Kong) which is regulated
by HKSFC (research reports containing any information in relation to, or advice on, futures contracts are not intended for issuance or distribution in Hong Kong and are not directed to, or
intended for issuance or distribution to, or use by, any person in Hong Kong); is issued and distributed in Taiwan by Merrill Lynch (Taiwan); is issued and distributed in India by DSP Merrill Lynch
(India); and is issued and distributed in Singapore to institutional investors and/or accredited investors (each as defined under the Financial Advisers Regulations) by Merrill Lynch International
Bank Limited (Merchant Bank) (MLIBLMB) and Merrill Lynch (Singapore) (Company Registration Nos F 06872E and 198602883D respectively). MLIBLMB and Merrill Lynch (Singapore) are
regulated by MAS. Bank of America N.A., Australian Branch (ARBN 064 874 531), AFS License 412901 (BANA Australia) and Merrill Lynch Equities (Australia) Limited (ABN 65 006 276 795), AFS
License 235132 (MLEA) distribute this report in Australia only to 'Wholesale' clients as defined by s.761G of the Corporations Act 2001. With the exception of BANA Australia, neither MLEA nor
any of its affiliates involved in preparing this research report is an Authorised Deposit-Taking Institution under the Banking Act 1959 nor regulated by the Australian Prudential Regulation
Authority. No approval is required for publication or distribution of this report in Brazil and its local distribution is by Merrill Lynch (Brazil) in accordance with applicable regulations. Merrill Lynch
(DIFC) is authorized and regulated by the DFSA. Research reports prepared and issued by Merrill Lynch (DIFC) are done so in accordance with the requirements of the DFSA conduct of business
rules. Bank of America Merrill Lynch International Limited, Frankfurt Branch (BAMLI Frankfurt) distributes this report in Germany and is regulated by BaFin.
This research report has been prepared and issued by MLPF&S and/or one or more of its non-US affiliates. MLPF&S is the distributor of this research report in the US and accepts full
responsibility for research reports of its non-US affiliates distributed to MLPF&S clients in the US. Any US person receiving this research report and wishing to effect any transaction in any
security discussed in the report should do so through MLPF&S and not such foreign affiliates. Hong Kong recipients of this research report should contact Merrill Lynch (Asia Pacific) Limited in
respect of any matters relating to dealing in securities (and not futures contracts) or provision of specific advice on securities (and not futures contracts). Singapore recipients of this research
report should contact Merrill Lynch International Bank Limited (Merchant Bank) and/or Merrill Lynch (Singapore) Pte Ltd in respect of any matters arising from, or in connection with, this
research report.
European Equity Strategy | 01 December 2016 37
General Investment Related Disclosures:
Taiwan Readers: Neither the information nor any opinion expressed herein constitutes an offer or a solicitation of an offer to transact in any securities or other financial instrument. No part of
this report may be used or reproduced or quoted in any manner whatsoever in Taiwan by the press or any other person without the express written consent of BofA Merrill Lynch.
This research report provides general information only. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or
other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). This report is not intended to provide
personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person. Investors should seek
financial advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed or recommended in this report and should understand
that statements regarding future prospects may not be realized. Any decision to purchase or subscribe for securities in any offering must be based solely on existing public information on such
security or the information in the prospectus or other offering document issued in connection with such offering, and not on this report.
Securities and other financial instruments discussed in this report, or recommended, offered or sold by Merrill Lynch, are not insured by the Federal Deposit Insurance Corporation and are not
deposits or other obligations of any insured depository institution (including, Bank of America, N.A.). Investments in general and, derivatives, in particular, involve numerous risks, including,
among others, market risk, counterparty default risk and liquidity risk. No security, financial instrument or derivative is suitable for all investors. In some cases, securities and other financial
instruments may be difficult to value or sell and reliable information about the value or risks related to the security or financial instrument may be difficult to obtain. Investors should note that
income from such securities and other financial instruments, if any, may fluctuate and that price or value of such securities and instruments may rise or fall and, in some cases, investors may
lose their entire principal investment. Past performance is not necessarily a guide to future performance. Levels and basis for taxation may change.
This report may contain a short-term trading idea or recommendation, which highlights a specific near-term catalyst or event impacting the issuer or the market that is anticipated to have a
short-term price impact on the equity securities of the issuer. Short-term trading ideas and recommendations are different from and do not affect a stock's fundamental equity rating, which
reflects both a longer term total return expectation and attractiveness for investment relative to other stocks within its Coverage Cluster. Short-term trading ideas and recommendations may
be more or less positive than a stock's fundamental equity rating.
BofA Merrill Lynch is aware that the implementation of the ideas expressed in this report may depend upon an investor's ability to "short" securities or other financial instruments and that such
action may be limited by regulations prohibiting or restricting "shortselling" in many jurisdictions. Investors are urged to seek advice regarding the applicability of such regulations prior to
executing any short idea contained in this report.
Foreign currency rates of exchange may adversely affect the value, price or income of any security or financial instrument mentioned in this report. Investors in such securities and instruments,
including ADRs, effectively assume currency risk.
UK Readers: The protections provided by the U.K. regulatory regime, including the Financial Services Scheme, do not apply in general to business coordinated by BofA Merrill Lynch entities
located outside of the United Kingdom. BofA Merrill Lynch Global Research policies relating to conflicts of interest are described at http://go.bofa.com/coi.
MLPF&S or one of its affiliates is a regular issuer of traded financial instruments linked to securities that may have been recommended in this report. MLPF&S or one of its affiliates may, at any
time, hold a trading position (long or short) in the securities and financial instruments discussed in this report.
BofA Merrill Lynch, through business units other than BofA Merrill Lynch Global Research, may have issued and may in the future issue trading ideas or recommendations that are inconsistent
with, and reach different conclusions from, the information presented in this report. Such ideas or recommendations reflect the different time frames, assumptions, views and analytical
methods of the persons who prepared them, and BofA Merrill Lynch is under no obligation to ensure that such other trading ideas or recommendations are brought to the attention of any
recipient of this report.
In the event that the recipient received this report pursuant to a contract between the recipient and MLPF&S for the provision of research services for a separate fee, and in connection
therewith MLPF&S may be deemed to be acting as an investment adviser, such status relates, if at all, solely to the person with whom MLPF&S has contracted directly and does not extend
beyond the delivery of this report (unless otherwise agreed specifically in writing by MLPF&S). MLPF&S is and continues to act solely as a broker-dealer in connection with the execution of any
transactions, including transactions in any securities mentioned in this report.
Copyright and General Information regarding Research Reports:
Copyright 2016 Bank of America Corporation. All rights reserved. iQmethod, iQmethod 2.0, iQprofile, iQtoolkit, iQworks are service marks of Bank of America Corporation. iQanalytics®,
iQcustom®, iQdatabase® are registered service marks of Bank of America Corporation. This research report is prepared for the use of BofA Merrill Lynch clients and may not be redistributed,
retransmitted or disclosed, in whole or in part, or in any form or manner, without the express written consent of BofA Merrill Lynch. BofA Merrill Lynch Global Research reports are distributed
simultaneously to internal and client websites and other portals by BofA Merrill Lynch and are not publicly-available materials. Any unauthorized use or disclosure is prohibited. Receipt and
review of this research report constitutes your agreement not to redistribute, retransmit, or disclose to others the contents, opinions, conclusion, or information contained in this report
(including any investment recommendations, estimates or price targets) without first obtaining expressed permission from an authorized officer of BofA Merrill Lynch.
Materials prepared by BofA Merrill Lynch Global Research personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflect
information known to, professionals in other business areas of BofA Merrill Lynch, including investment banking personnel. BofA Merrill Lynch has established information barriers between
BofA Merrill Lynch Global Research and certain business groups. As a result, BofA Merrill Lynch does not disclose certain client relationships with, or compensation received from, such issuers in
research reports. To the extent this report discusses any legal proceeding or issues, it has not been prepared as nor is it intended to express any legal conclusion, opinion or advice. Investors
should consult their own legal advisers as to issues of law relating to the subject matter of this report. BofA Merrill Lynch Global Research personnel’s knowledge of legal proceedings in which
any BofA Merrill Lynch entity and/or its directors, officers and employees may be plaintiffs, defendants, co-defendants or co-plaintiffs with or involving issuers mentioned in this report is based
on public information. Facts and views presented in this material that relate to any such proceedings have not been reviewed by, discussed with, and may not reflect information known to,
professionals in other business areas of BofA Merrill Lynch in connection with the legal proceedings or matters relevant to such proceedings.
This report has been prepared independently of any issuer of securities mentioned herein and not in connection with any proposed offering of securities or as agent of any issuer of any
securities. None of MLPF&S, any of its affiliates or their research analysts has any authority whatsoever to make any representation or warranty on behalf of the issuer(s). BofA Merrill Lynch
Global Research policy prohibits research personnel from disclosing a recommendation, investment rating, or investment thesis for review by an issuer prior to the publication of a research
report containing such rating, recommendation or investment thesis.
Any information relating to the tax status of financial instruments discussed herein is not intended to provide tax advice or to be used by anyone to provide tax advice. Investors are urged to
seek tax advice based on their particular circumstances from an independent tax professional.
The information herein (other than disclosure information relating to BofA Merrill Lynch and its affiliates) was obtained from various sources and we do not guarantee its accuracy. This report
may contain links to third-party websites. BofA Merrill Lynch is not responsible for the content of any third-party website or any linked content contained in a third-party website. Content
contained on such third-party websites is not part of this report and is not incorporated by reference into this report. The inclusion of a link in this report does not imply any endorsement by or
any affiliation with BofA Merrill Lynch. Access to any third-party website is at your own risk, and you should always review the terms and privacy policies at third-party websites before
submitting any personal information to them. BofA Merrill Lynch is not responsible for such terms and privacy policies and expressly disclaims any liability for them.
Certain outstanding reports may contain discussions and/or investment opinions relating to securities, financial instruments and/or issuers that are no longer current. Always refer to the most
recent research report relating to an issuer prior to making an investment decision.
In some cases, an issuer may be classified as Restricted or may be Under Review or Extended Review. In each case, investors should consider any investment opinion relating to such issuer (or
its security and/or financial instruments) to be suspended or withdrawn and should not rely on the analyses and investment opinion(s) pertaining to such issuer (or its securities and/or
financial instruments) nor should the analyses or opinion(s) be considered a solicitation of any kind. Sales persons and financial advisors affiliated with MLPF&S or any of its affiliates may not
solicit purchases of securities or financial instruments that are Restricted or Under Review and may only solicit securities under Extended Review in accordance with firm policies.
Neither BofA Merrill Lynch nor any officer or employee of BofA Merrill Lynch accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of
this report or its contents.
38 European Equity Strategy | 01 December 2016