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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 de-rate 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
Bank of America
Merrill Lynch
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