Summary – Hinging on oil and inflation
Our theme “Slower slowdown – restrained recovery” from end-April continues to build. The
surprising resilience of economic growth has shifted the market’s focus from the credit
crunch to inflation concerns, and equity markets are back at the March lows.
Due to the inflation concerns, the equity market is strongly focused on the oil price; it has
become increasingly negatively correlated with the oil price. It is hard to imagine that the oil
price declines strongly without severe demand destruction, despite a falling oil price being a
consensual view. We fear that to see enough demand destruction, the oil price has to
temporarily rise further and/or central banks and governments have to increasingly sacrifice
growth. This would not be supportive of equities in the short term.
Over the last few months, the growth profile for 2008 and 2009 expected by our economists
has flipped. 2008 is now not looking quite as weak as it did, but prospects for 2009 have
been marked down further to 3.5%. Against this backdrop we expect earnings estimate
downgrades to continue. Our top-down earnings growth forecast for Europe at 0% (5%) for
2008E (2009E) remains clearly below the consensus bottom-up number of 3% (13%).
We continue to believe that at current levels a full cyclical downturn of profitability is priced in
by European equities. The current level of the P/B multiple accounts for a 4.1pp drop of the
trailing RoE to 11.5%, equalling a 26% decline in earnings. We believe that one needs to
assume a quick loss of 15 years of structural gains in profitability to see further valuation
downside. The current rise in inflation does not change this conclusion. We analyse the
impact of rising inflation on the “fair” valuation multiples and show that for the “fair” P/E to
drop below the 25-30 year average, bond yields need to rise beyond 6-7%.
Overall, we believe valuation is clearly supportive at the current level, offering substantial
upside if macro developments turn out to be more benign than expected or when the
downturn that is already priced in appears and bottoms out. For now, we continue to expect
the market to remain in the range observed since the January sell-off. With increasingly
bearish sentiment we believe the market is unlikely to sustainably drop below the lower end
of the range. Any further decline could provide an attractive (short-term) buying opportunity.
In contrast to general market perception, we neither find evidence that the sector
performance divergence over the last 6-12 months has been extreme, nor that there exists a
typical H2 sector performance reversion. We believe investors should not be aggressively
pushing the idea of a major sector rotation. Consumer Discretionary and Financials will likely
only rebound sustainably if the oil price comes down without severe demand destruction. If,
however, the oil price temporarily has to rise further to create enough demand destruction or
central banks and governments need to sacrifice growth, a rotation into Consumer Cyclicals
does not look like a good idea to us. We think Health Care and Telecoms would be the better
way forward in these cases.
We are largely staying the course with our country, theme and sector positions, which
generally have worked in our favour. We continue to expect Europe to lag the US. In Europe
we still favour the UK over the continent, where we are particularly U/w Spain. We still prefer
Growth to Value, focus on large caps and favour globalisation beneficiaries.
By sector, we stick to our sizable Consumer U/w in favour of Oil & Gas, Health Care,
Technology and Insurance. In fact, this month we are even increasing this relative position by
reducing Retail from 100bp U/w to 150bp U/w to raise the Health Care O/w to 200bp. Our
key O/w positions are now Oil & Gas, Health Care, Insurance and Technology. Banks,
Industrial G&S and Travel & Leisure are small O/w. Our key U/w positions are Autos, Retail,
Food & Beverage, Construction and Personal & HH. G. Media is small U/w.

Sector Strategy in two minutes
STOXX sectors Our sector stance
Basic Resources
Sector continues to outperform; Coal, Iron ore and Steel are very strong. Our analysts have
substantially lifted their long-run commodity price assumptions and remain positive on the
miners and steel companies; Basic our models are more negative. We stay neutral and U/w Paper.
Materials
Chemicals
Oil price inflation is negative for specialties, but positive for BASF and other upstream
chemicals with strong pricing power. Earnings estimate upgrades remain strong so far, but
outlook is more mixed and our models are negative. We stay neutral.
Autos & Parts
Consumers' intentions to carry out big ticket purchases have dropped strongly because of
record inflation. High oil prices are very negative for Auto sales, especially for expensive, high
margin cars with high petrol consumption. High steel prices are also negative. We stay U/w.
Food & Beverage
Inflationary pressure is a negative, in the Eurozone, but also in emerging markets as reflected
by the profit warning of Coca-Cola Hellenic Bottling. Valuation continues to look demanding and
we stay U/w.
Consumer
Goods
Personal &
Household Goods
Consumer sentiment in Europe continues to deteriorate because of high inflation, slowing
economies, and weakening housing markets. In addition, the sector ranks weak on our models
due to unattractive valuation and weak technicals. We stay U/w.
Media
Sector ranks high on our models, but our analysts remain very cautious in light of deteriorating
advertising trends underpinned by the profit warning of Trinity Mirror and general weakening of
European consumer sentiment. We stay U/w.
Retail
Eurozone Retail PMI fell strongly in June. Q2 average signals the greatest decline since 2004.
Deteriorating consumer sentiment could feed through strongly to sales and margins of
European retailers. We increase our U/w position by 50 bp despite a neutral scorecard.
Consumer
Services
Travel & Leisure
Sector continues to rank high on our models due to attractive valuation. Bus companies could
well benefit from increasing demand due to higher oil prices whereas Airlines should continue
to suffer. We stay O/w Travel & Leisure and continue to U/w Airlines.
Banks
Our models continue to suggest an O/w in the sector. The sector looks inexpensive, although
momentum indicators have deteriorated since last month. EPS estimate revisions are coming
down aggressively and technicals are weak. However, we believe that were the market to
rebound, which we expect, Banks are likely to enjoy a relief rally and outperform.
Financial Services
We stay U/w despite the sector’s recent underperformance. Fin. Svs. is a suggested
Neutral on our models, and also the least preferred among the Financials. The sector
continues to look expensive and momentum is weak.
Financials
Insurance
We stay O/w. The sector looks attractive on our metrics - it looks inexpensive and
momentum is improving as is the sector’s relative risk profile. Assuming the market
bounces back from current levels, we expect the sector to outperform.
Healthcare
Despite the sector’s strong relative performance, we are increasing our O/w this month. Health
Care should benefit should the dollar stabilize. The sector looks attractively valued and earnings
momentum is relatively robust.
Construction &
Materials
Weakest performer last month and valuation is starting to look less demanding. But negative
news flow on European housing and construction continues strongly. This is especially true for
Spain and the UK, but also includes a profit warning from a French home builder. We stay U/w.
Industrials
Industrial
Goods & Services
Within the sector our analysts remain positive on Capital Goods because of ongoing strong
growth in China and the historically positive experience of compensating for raw material cost
inflation through price increases. We keep our small O/w and prefer Capital Goods.
Oil & Gas
Our commodity strategists do not believe that we are likely to see a major fall in the oil price. In
this context we are likely to see more upward earnings estimate revisions to the Oil & Gas
sector. Our models suggest a sector O/w – looks inexpensive and is enjoying solid momentum.
Technology
The sector is vulnerable to slowing growth, but is facing relatively low input cost inflation as it
depends less on materials and energy as an input. We note relatively strong insider buying and
that investors are U/w Tech. Hence, we stay O/w.
Telecoms
Market performer over the last two months. Earnings momentum has remained weak and
operators are likely to remain cautious on the outlook. Models suggest a modest O/w.
Seasonality is not yet in favour and sector still looks over-owned; we stay neutral for now.
Utilities
The Utilities sector looks expensive, but is enjoying strong earnings momentum and
strong technicals. Investors have reduced their exposure to the sector and are now
slightly U/w. All in all we stay Neutral.