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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" 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 , Bankof America 20 European Equity Strategy | 01 December 2016 Merrill Lynch HOUSE_OVERSIGHT_014479