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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 PE-relative 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
Bank of America Merrill Lynch
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