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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? Chart 44: Wider Italian bond spreads correlate negatively with equities 35 6.0 5.0 3.0 40 2.5 3.0 2.0 2.0 45 US 5y5y inflation swap 10 ——— Euro Sy6y inflation swap - ——=Italy-Germnay 10 year bond spread (%) 1.0 4 0109 O10 O1/11 O12 O13 O14 O1M5 01/16 01/10 ori O113 O74 0116 Source: BofA Merrill Lynch Global Research, Bloomberg Source: BofA Merrill Lynch Global Research, Bloomberg Bankof America Merrill Lynch European Equity Strategy |O1 December 2016 19 HOUSE_OVERSIGHT_014478