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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: e 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 PE- relatives 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"? 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. e 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. e 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 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. e Staples approaching 2010/14 lows on PE-relative. Staples have also de- rated 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 . Bankof America Merrill Lynch European Equity Strategy |O1 December 2016 23 HOUSE_OVERSIGHT_014482